Target Slashes Prices, but It's Profits That Will Be Cut

Target (NYSE: TGT) has few options other than to engage in a broad price-cutting strategy. Long under pressure from Wal-Mart and to remain competitive, the mass-merchandising retailer has often responded with select promotional deals to keep customers coming back.

And though chains such as Kroger, Supervalu, and even Costco felt the heat from deep-discounting grocers Aldi and Lidl as they expanded their U.S. presence, Target was finally forced to make a more decisive move after Amazon bought Whole Foods Market and immediately began cutting prices at the organic-foods grocer.

In a blog post announcing the decision, Target said it's cutting prices on thousands of products, from cereal and baby formula to razors and toilet paper.

Low prices are just the beginning

The move, however, comes with margin-crushing potential that was already in question after the company promised earlier this year to spend $7 billion to remodel its "old, tired" stores.

The stock was hammered after management said it expected to only earn $3.80 to $4.20 per share when analysts had been predicting $5.00 per share. While Target also pledged to invest in e-commerce, new brands, and price cutting, the real worry was the lasting impact on margins as the space becomes more competitive, and the retailer was committing to opening more stores even as rivals reduced their footprint.

Now, Target is going ahead with the lower-price portion of the program in a bid to drive volume. It certainly needs something, because comparable-store sales have been falling for the past year, only breaking the skid last quarter, when it posted a 1.3% gain.

Do sales matter?

The switch to an everyday-low-price strategy is an attempt to give customers assurance that when they shop Target, they're getting a good price without having to hunt for bargains. It looks to be a smart strategy that keeps the company competitive, while Wal-Mart spends billions on "price investments" and Amazon aggressively positions Whole Foods as a more affordable shopping destination. In the first week that Amazon lowered Whole Foods prices, it sold a half-billion dollars' worth of private-label 365 by Whole Foods goods online. However, there's no guarantee it'll be a slam dunk. As J.C. Penney discovered, customers can sometimes shun low prices for the treasure hunt thrill of a big sale.

But Target's investments in pricing -- even before the company-wide cuts -- are pinching profits. In the second quarter, the retailer said operating margin declined year over year to 6.8% from 7.7%, while gross margin narrowed to 30.5% from 30.9%, in part because of the efforts to improve pricing and promotions.

Now that it lowered the bar across its entire store, investors can expect rates to be squeezed even further.

Missing the target

While Target stock has recovered from the drop it initially experienced after the company announced the new strategy, the real test will come when it reports third-quarter earnings. Investors will be able to see whether the price cuts helped increase traffic enough to offset the drag on profitability.

Pricing does play a role in staying competitive in today's market, but it isn't the only factor consumers consider when deciding where to shop. And though it is a discounter, Target is decidedly not Wal-Mart, either. It has tried to compete on price in the past ... with mixed results.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.