In Their Own Words: One Retailer To Buy, One To Sell In 2014

| About: Costco Wholesale (COST)

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Transcripts offer one of the best research tools that investors can use to analyze future prospects. More often than not, management would mention a small fact, or tidbit that is normally ignored by investors.

Buy: Model one of the best in retail, international growth strong

On October 9, Costco (NASDAQ:COST) announced its fourth quarter 2013 results. The company reported an EPS of $1.40 which missed the consensus estimate by six cents. On December 11, the company announced its first quarter 2014 results. The company reported an EPS of $0.96 which missed the consensus estimate by seven cents.

So why is Costco a retailer to buy following two consecutive quarters of EPS misses?

IT Modernization

The reason for the miss was the company's increased SG&A spending due to IT modernization costs. These costs will remain elevated into fiscal 2014 and beyond as shopper behavior continues to change and the company continues to expand and grow its online business.

Richard Galanti, the company's CEO had the following to say during the company's first quarter 2014 conference call on December 11.

The one that I pointed out now, for probably the last five fiscal quarters, all the quarters last year plus this first quarter, is IT modernization. We have finally had the courage, I think, a few years ago, to recognize that we had great home-grown systems that were kept together and allowed us to do what we wanted to do, but as we're becoming more global, and bigger, and getting to a platform and a whole IT infrastructure, that will serve us as we go from hopefully $100 billion to $200 billion in the next many years.

2014 the year of accelerating growth

The company confirmed that it has an ambitious plan of accelerating growth in fiscal 2014. The company plans on opening 36 Clubs in the year, representing a 5.5 percent square footage growth. Galanti offered a "realistic" scenario of growth during its December 11 conference call.

Inevitably a few of these will probably get delayed. So I would estimate that a number in the low to mid 30s is more likely still a pretty good increase about the 16 and 26 new warehouses opened in each of the past two fiscal years.

Half of the company's new Clubs will be in the U.S. with the rest abroad, including entry into Spain with two clubs planned. These stores should be exciting for shareholders as they are higher margin, and generally higher return properties for the company.

Costco is one of the few retailers that sees an improved economics outside the U.S. and counts on these locations to drive growth. 70% of the company is in the U.S. with another 10%-12% in Canada and the company.

History of dividend growth likely to continue

The company offered a $7 special dividend in fiscal 2013 in addition to a quarterly dividend of $0.31 which was up 13% from the previous year. The company repurchased $34 million worth of shares at the beginning of the year and continues to look at opportunities to increase this number info fiscal 2014.

Again, from the company's December 11 conference call.

We're not sitting around looking at special dividends as an example. I'm sure next spring the board will consider what they want to do with the regular dividend, and again, I don't want to be coy, but we'll continue to look at stock buybacks and let you know next quarter what we did or didn't do. But we view all those vehicles as logical vehicles for us going forward.

Sell: This retailer is not showing early international success

During Costco's December 11 conference call, Galanti described the Canadian market as "stronger than the U.S. It has had a great economy, it's been a great business for us."

Unfortunately, Target (NYSE:TGT) can't describe its recent expansion to Canada in a similar positive tone. Target launched a massive Canadian expansion in 2013, opening hundreds of stores across the country. The company had hoped its Canadian expansion would drive future growth and contribute $6 billion in annual sales and $0.80 in earnings by 2017.

During the company's Financial Community Meeting on November 2nd, John Mulligan, Executive Vice President and Chief Financial Officer said the following:

We continue to believe the Canadian Segment will meet our long-range financial goals in 2017.

The company has officially set the bar and investors will hold management accountable for any future deviations. Disappointing results, or the company's inability to reach its target will likely result in further shareholder frustration.

The company's profit margin ramp up in Canada continues to be slower than anticipated given an increasingly competitive and promotional environment, including Wal-Mart's (NYSE:WMT) $450 million investment in its Canadian Supercenter expansion.

Higher labor costs, taxes and especially fuel prices relative to the U.S. continue to drag down the bottom line.

Most importantly, the company had only one shot at cracking the Canadian market and it failed in two key areas.

Annoyed customers

Target's expansion to Canada has resulted in many annoyed customers who are still dealing with empty shelves and low inventory complaints. During its November 2nd presentation, management acknowledged this will remain a persistent problem in to 2014.

Every time we open a store in the U.S., we encounter a set of dynamics: excess inventory on some items, out-of-stocks on other, higher levels of shortage as processes and systems are optimized.

In Canada this is happening in all of the stores simultaneously and it's particularly visible, because we report Canada as a separate segment. Inevitably, these dynamics will persist into the fourth quarter as we experience our first holiday season across Canada. As we move into the New Year, we expect these dynamics to improve and we expect meaningful improvement in Canadian segment EBITDA both quarter-over-quarter and year-over-year throughout 2014.

Not convinced of the severity of the issue? All you have to do is go to Target Canada's Facebook page to read the comments. Various other blogs and social media venues are full of frustrated customers that are fed up with the inventory issues.

Competitive pricing? Not so much

Now it's important to mention pricing. Target Canada never promised to offer prices that are on par with the cheaper Target stores in the U.S.

When Target first expanded to Canada, management made it perfectly clear that its Canadian prices will not be on par with the American stores. Bummer. But what the company did offer was prices that would be "competitively priced" with retailers in Canada, according to a company spokeswoman, Lisa Gibson.

"In certain cases, the prices will actually be completely on par with U.S. prices and in some cases there might be some differences, but… our overall goal is to make sure we're competitive with the marketplace," Gibson added.

With many savvy Canadian shoppers that already know the pricing of items in stores south of the border, Target Canada is finding it more difficult to retain customers.

Analysts at Desjardins Securities were quoted in the Wall Street Journal offering their take. "Women who really knew Target- those who have lived in the U.S. - said the assortment wasn't as good as it is in the U.S. Women who knew Target reasonably well - those who cross-border shop - said the prices were higher in Canada. And the women who don't really know Target, they said, 'Well, what's the big deal?'"

Once a month or so I flock down to the U.S. with my fiancée for a shopping day trip. The Target in Plattsburgh (upstate New York) is roughly a one hour drive from Montreal. When factoring in a substantially cheaper price at the gas pump, an exchange rate within 5% parity with the greenback and the 5%-20% savings on many products we buy at Target, the trip is certainly worth it. Plus Plattsburgh just recently opened up a Chipotle Mexican Grill and a Buffalo Wild Wings, making the trip even more desirable.

During the company's November 2nd presentation, management attempted to defend the price disparity with Target.

Sometimes people compare prices from Canada to the United States. That would be like comparing prices in Boston compared to what we have in rural Iowa. I mean, we have a lot of variability in our pricing in the United States but most importantly, what we focus on is being priced properly in each and every trade area that we operate in. The same approach holds true in Canada.

I suppose this is a valid argument, but it is still hard to justify to the satisfaction of consumers.

According to Google Maps, 1,285 miles separates Boston from Iowa. 62 miles separates Montreal from the Target in upstate New York. 98 miles separates Canada's most populous city, Toronto, with the closest Target in Buffalo, New York.

I'm not buying management's "apples to oranges" analogy.


They said it, not me.

Management at Costco has made an exceptionally convincing case for an investment. The company is one of the few that can operate a successful model outside of the U.S.

Target on the other hand, not so much. The lack of success and the negative attention Target Canada has received over its perceived pricing disadvantage and supply chain issues essentially negates one of the most compelling investment themes in Target that existed two years ago.

Costco is up around 20% year to date while Target is barely even. If investors want exposure to a retailer in their portfolio, investors could consider buying Costco and selling Target.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.