Updated 11/16/2011

Is Target shooting itself in the foot by trying to be more like Wal-Mart -- or is it making up ground on its much bigger rival?

Target's third-quarter earnings, out Wednesday, again showed gains, more evidence that attempts by the champion of "cheap chic" to look more like the chieftain of "just cheap" are paying off for shareholders.

To cope with tough economic times after losing out to Wal-Mart Stores (WMT, news) during the economic slump three years ago, Target (TGT, news) hatched a game plan that makes it more like the most successful retailer on the planet. That would be the one Sam Walton created.

Of course, Target would never describe the strategy that way, and the plan is a work in progress. But we're starting to see signs that it's working. Target has posted sales gains of late, for example, while Wal-Mart's sales have slumped for nine of the past 10 quarters. Wal-Mart reported Tuesday that it broke that string in the third quarter, but profits fell slightly. Target reported Wednesday that third-quarter sales rose 4.3%, with profits up 3.7%.

We'll learn more after the all-important Black Friday results come in later this month.

image: Michael Brush

Michael Brush

The game plan

Boiled down, Target's plan calls for a nationwide rollout of grocery departments along with storewide price cuts. Those are supposed to bring in more customers more often, with Target hoping they then spend enough on more-profitable cheap-chic apparel, household goods and beauty supplies to boost profits.

Some analysts worry that this won't end well. After all, there's little profit in selling groceries, compared with apparel, home furnishings and personal-care goods, the more traditional fare at Target stores. And offering a regular storewide discount, with a 5% off loyalty card, is not necessarily a recipe for boosting profits.

"We think the shares are nearly fully valued as Target transitions into more of a grocery store," says Morningstar analyst Michael Keara. "Target is using the Wal-Mart strategy, but we do not see nearly the same degree of success." Keara has a three-star rating on the stock, essentially a grade of "C."

But drill down, and there's a good case to be made that Target's strategy makes sense. In fact, there's already some evidence that it is working. If the trends continue, the plan could reward investors who buy shares now and have the patience to wait a few years for the plan to pay off.

The key: Customers who come in for low-margin groceries or sign up for the 5% discount have to buy enough extra stuff to offset the hit to margins. Here's why this strategy just might work.

A wake-up call

Target shareholders got a shock during the 2008-2009 economic slump. Consumers are supposed to "expect more, pay less" at Target. But during the slump, shoppers clearly opted for "always low prices" at Wal-Mart, the retail giant's old marketing tagline.

Target sales slumped, and Wal-Mart sales did well. (Throughout this column, I'm referring to sales results for stores open more than a year, because it is a better measure than total sales, which include the impact of store openings and closings.)

Not surprisingly, Wal-Mart investors were rewarded; Target shareholders, not so much. Wal-Mart advanced 18% from the start of 2008 to the end of 2009, but Target shares dropped and wound up going nowhere for those two years.

Emerging from that dust-up, Target has launched two major steps to try to fight back -- and become more like Wal-Mart -- in an ongoing economic environment of cautious consumers and sluggish growth.

Cheap-chic cuisine and the 5% discount

Target is in the midst of rolling out grocery sections in stores to attract more customers, as Wal-Mart has done. (Wal-Mart is now the nation's largest grocer, selling 39% of the country's groceries.)

Target hopes to have grocery sections, called PFresh, in 900 stores by the end of this year. By late 2013, it wants to have about 1,500 stores PFreshed -- nearly all of them. Target currently has about 1,770 stores.

Let's be clear. Target is not trying to match Wal-Mart in food. Target doesn't want to be a grocery supercenter. In a PFresh, there's no in-house bakery and no deli; you'll find only prepackaged bread and deli meats. It's more about convenience than offering a place where a family can do all its weekly grocery shopping, says Howard Davidowitz of Davidowitz & Associates, a retail consulting and investment banking firm in New York.

Target is definitely not matching Wal-Mart on price, either. That would be tough to do given Wal-Mart's size, which allows it to drive down prices from suppliers. A recent comparison of prices by retail sector analysts at JPMorgan Chase showed that Wal-Mart prices for groceries and consumables were 7% lower than those at Target.

And Target won't be passing Wal-Mart overall anytime soon. Wal-Mart was the nation's biggest retailer at the start of this year, with $421.9 billion in annual global sales. Target placed third, with $65.8 billion in annual sales, according to the National Retail Federation.

Still, the logic is similar. Target wants to use groceries to lure shoppers in more often, assuming they'll wander into other areas of the store to buy stuff that sells with higher profit margins -- its cheap-chic merchandise.

The other change at Target that's making it more like Wal-Mart is a loyalty program called REDcard Rewards. This program offers a standing 5% discount on anything purchased with a Target credit card or debit card. As with groceries, the goal is to get shoppers in more often so they buy enough extra stuff to make the discounts pay off for Target.

And the winner is . . .

How's all this working out? Pretty well, but it's still a mixed picture.

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First, the good news. So far this year, Target has been beating up Wal-Mart in sales growth, points out Drew Weitz of Weitz Funds, which owns Target in its Weitz Partners III Opportunity fund (WPOPX), which outperforms peers over the long term and carries a five-star rating at Morningstar. The introduction of groceries and the 5% discount have a lot to do with this advantage.

Target posted 3.9% sales growth in the second quarter, following a 2% gain in the first quarter. In contrast, Wal-Mart sales contracted again in the second quarter, capping nine straight quarters of sales declines. More recently, Wal-Mart has finally been posting slight sales gains since July and was able to break the string of declines in this week's earnings report. But Target sales have been going up much more, at 5.3% in September and 3.3% in October.

Target believes PFresh is responsible for a percentage point of the year-over-year sales gains cited above. "In addition to telling us that they like their new store, guests show us by increasing their visits and spending in remodeled stores," CEO Gregg Steinhafel said in the company's second-quarter conference call.

The discount card is also helping. Converting customers to a REDcard typically increases store visits by 40% to 50%, says Target. And people who already had a Target card and activate the 5% discount increase visits by about 10%. By the end of the year, Target thinks the 5% discount will be boosting year-over-year sales by 2 percentage points.

A big problem, though, is that all of this is causing profit margins to slip, at least by one measure, as predicted by Morningstar's Keara. Gross margins, defined as sales minus the cost of goods, have been falling slightly. That's not a trend you want to see in retail. But it might not tell the whole story, for two reasons.

First, when you factor in fixed overhead, as well as the cost of the stuff that's sold, you can see the beginnings of a payoff in Target's strategy. Simply put, overall sales are growing faster than this broader measure of costs, says Weitz. So while Target is boosting sales by adding lower-margin goods and discounts, it's layering more sales on top -- a recipe for success, says Maile Clark, an analyst with MFS investment Management.

A nagging problem, though, is that customers stepping up their grocery shopping aren't wandering over into other parts of the store to buy clothing and household furnishings often enough. While the food business is growing by leaps and bounds -- sales are growing by around 15% annually -- Target is seeing only "a very slight increase" in the sales of other stuff as a result, says Steinhafel.

Time will tell, but . . .

Target experts aren't too concerned. They argue that the strategy will take time to pay off. "I think it's still early," says Regina Lombardi, an analyst who follows Target at BBH Core Select Fund (BBTEX).

She thinks this Target game plan, along with a few other initiatives like expansion into Canada and the rollout of smaller-format stores over the next few years, will boost the retailer's earning power enough to suggest that the stock currently trades "significantly" below its intrinsic value. She won't say by how much, but this discrepancy explains why her investment firm took a position in Target last summer. Lombardi is worth listening to, because the fund she works for significantly beats competitors over the long term. It has a five-star Morningstar rating, the highest possible mark.

Trading for 12 times earnings, Target also appears cheap to David Abella who manages Rochdale Dividend & Income (RIMHX), which beats competing funds nicely. Target's median price-earnings ratio over the past several years is around 15, which suggests it may be inexpensive right now. The price-earnings ratio, which compares stock price to earnings, is a common measure of a stock's value.

Abella says he's looking closely at Target and may consider a purchase once there are more signs that Target sales and the economy are getting better. If the economy improves, Target stock "could be quite strong for a while," he says. "It's not something you have a one-month window to get into."

One problem to watch is Target's website. Last summer, when Target moved its website off servers run by Amazon.com (AMZN, news), the site suffered severe outages. It seems to be working better now, but we're dangerously close to peak holiday sales season, starting just around the corner with Black Friday. And the problems have been cropping up at a time when Target is trying to promote its site by offering REDcard holders free shipping. "They've got a lot of work to do in online sales," says Davidowitz. "But I look at it as potential."

That might be. But if Target doesn't get all the bugs out of its Website, Black Friday -- the day after Thanksgiving -- could give Target's cute mascot dog a black eye instead of the red ring it currently sports.

At the time of publication, Michael Brush did not own or control shares of any company or fund mentioned in this column.

Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.