Big Profits Await for Companies Going Small

The U.S. loves cities. According to the CIA's The World Factbook, 82% of the population lives in the country's urban areas. That's an area that has been heavily penetrated by smaller stores and online shopping. Big-box stores have been unable to make any meaningful foray inside American cities -- yet. But a series of announcements from big retailers has made it clear that the situation is about to change. Tapping that market could bring in huge revenues, and investors would be wise to jump on board.

Who said what, now?
Wal-Mart (NYSE: WMT  ) stores typically run over 100,000 square feet in size. These stores would cover an entire block in many cities. The cost of buying that much urban space would be astronomical, so Wal-Mart has created a smaller store. Walmart Express stores are 15,000 square feet and carry items that people might need on short notice. This makes them less focused on big-screen TVs and more focused on essentials like groceries and medicine.

Wal-Mart's plans put it in direct competition with Target (NYSE: TGT  ) , which is not surprising. Target's new City concept is on a slow road to launch, with the company expecting to have fewer than 10 locations open by the end of 2012. Both Target and Wal-Mart have watched as, for the first time in more than 20 years, urban populations have grown faster than their suburban counterparts. Target is hoping that those urbanites will jump on the opportunity to have a Target store in their backyard. In an oddly chosen analogy, Target VP John Griffith has said, "It's like we've been dating long distance."

Wal-Mart has already started to earn money on its Express stores. The company reported last month that the locations had turned a profit less than a year after opening. The 10 test stores that the company has built are a mix of urban and rural locations, with the three urban stores located in the Chicago area.

Nothing new under the sun
The big U.S. chains have undoubtedly learned a thing or two from monster U.K. retailer Tesco (OTC: TSCDY). While the retailer has had difficulty breaking into the U.S., in the U.K. it has done extremely well in urban areas. Tesco Metro stores are about the same size as Walmart Express stores, and the company has 190 running across the U.K.

Tesco has taken the model one step further and developed web-only "stores." These are essentially warehouses built near densely populated areas which act as quick order fulfillment sites. Tesco has opened four of the warehouses in and around greater London and has plans to increases spending on the stores over the coming year.

The bottom line
In playing this sector for this reason, investors are making two assumptions. The first is that the migration back to cities will continue in the U.S. I think this is a fair assumption. The housing crash made city life a better deal for lots of Americans, the recession pushed jobs back into cities, and the credit crisis made it harder for people to buy houses in the 'burbs.

The second assumption is that the cost benefit will work out for Wal-Mart and Target. While Walmart Express has proven itself in a limited test, there has not been much regional variation so far. Target's model has yet to even be tested. There's a lot riding on these companies' ability to meet pent-up demand in a cost-efficient way.

But again, I think this is a fair assumption. Wal-Mart is nothing if not efficient, and for that reason it's my pick of the two. I think Target has a lot to offer U.S. cities and that the company's brand fits urban life better than Wal-Mart's, but I'm not sold on Target's ability to execute yet. I don't think Target is a bad investment in this space; it's just not the one I'd bank on.

One more thing before you go
The final caveat in this is, as always, Amazon.com (Nasdaq: AMZN  ) . Online retailers are one of the main beneficiaries of the status quo. Being unable to make a quick trip to Target makes shoppers more inclined to make purchases online and wait for delivery.

Wal-Mart has indirectly addressed this problem by saying that its stores will carry more spontaneous-style items. While this means it won't have to worry as much about Amazon, I'm concerned that the companies will miss out on revenue opportunities by aiming too low or by not diversifying stock enough. Tesco has overcome this issue in the U.K. by having some stores focus on groceries and some on retail, which might be an option further down the line.

With a potential surge in domestic retail, it only makes sense to look across the globe for similar opportunities brought on by the economic climate. The Fool has picked one of these global companies as its top stock for 2012. You can read the in-depth report for free and get in before the market realizes what's going on. Get your free copy today.

Fool contributor Andrew Marder does not own any of the stocks mentioned in this article. The Motley Fool owns shares of Amazon.com and Tesco. Motley Fool newsletter services have recommended buying shares of Tesco and Amazon.com. Motley Fool newsletter services have recommended creating a diagonal call position in Wal-Mart Stores. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (6) | Recommend This Article (3)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 20, 2012, at 12:52 AM, maiday2000 wrote:

    A very rational move by these companies, at least in the short term. Who knows how much longer the government largesse on social welfare programs can continue to cause that bulge in urban dwellers' wallets?

  • Report this Comment On June 20, 2012, at 1:41 AM, SuntanIronMan wrote:

    The US defines 'Urban Population' in such a way to make that statistic basically meaningless. 'Urban Population' can include areas that most people would consider fairly-rural (a town with a couple thousand people, for example).

  • Report this Comment On June 20, 2012, at 1:46 AM, SuntanIronMan wrote:

    And by a couple thousand, I mean it could be as low as 5,000 people or so. That's would be considered urban.

  • Report this Comment On June 20, 2012, at 11:19 AM, TMFRedRam wrote:

    @WhichStocksWork

    Thanks for pointing the detail out there. As it turns out, though, American urban areas are defined in such a way that they all have over 50,000 people in them. While Wikipedia is not a government reference, you can check the basics out here: http://en.wikipedia.org/wiki/List_of_United_States_urban_are...

    Your point is still valid, though. A lot of these places aren't necessarily 'super dense' or cities in the way that we typically think of them (NYC, LA, etc.).

    Cheers, Andrew

  • Report this Comment On June 20, 2012, at 5:28 PM, SuntanIronMan wrote:

    @TMFRedRam

    You have two categories of urbanization that are included in that 82% stat.

    Urban Areas are defined as over 50,000 people.

    Urban Clusters are defined as less than 50,000 people, but 2,500 or more people.

    So basically, anything over 2,500 people is considered urban by the US.

  • Report this Comment On June 20, 2012, at 5:30 PM, SuntanIronMan wrote:
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