Can Neighborhood Market Stores Save Walmart?

Big-box retailers are having a hard time convincing fickle consumers to spend more at their stores, and their response has been to turn to smaller formats. Both Wal-Mart (WMT 1.01%) and Target are testing small stores, which could be key to their turnarounds or the cause of their future demise.

The question for Wal-Mart is whether it can turn around abysmal same-store sales and a rapidly falling return on investment, and persuade urban consumers to spend more money at its stores.

As someone who regularly walks to his local grocery store (which is about the same size as a Wal-Mart Neighborhood Market) for groceries and other everyday items, I can see the appeal. But this is a well-established industry with companies that have large footprints and strong customer bases.

Just what is Wal-Mart up against and how big is the opportunity?

The grocery market is a big target for Wal-Mart's Neighborhood Markets. Photo source: Wal-Mart. 

How big is the Neighborhood Market?
The concept of Wal-Mart's Neighborhood Market is to offer everyday items in convenient, local locations that require less space than a Supercenter. Think of it as an urban mini-Wal-Mart. 

The stores won't have the Supercenter selection of furniture, electronics, and clothing, but it will have everyday items like groceries, detergent, and a pharmacy along with Wal-Mart's low prices. If it sounds like that retail model is targeting dollar stores, neighborhood pharmacies, and local grocery stores, it's because it is. That's why these businesses can give us a good gauge of how big an opportunity this is for Wal-Mart long-term.

For Wal-Mart to make a significant impact on its top or bottom line with the Neighborhood Market, it needs to build out a footprint quickly in a highly competitive retail market. Right now, the plan is to open 270 to 300 small-format stores this year and to have 500 Neighborhood Market locations by early next year. This experiment fits into a company worth $244 billion, with $476.3 billion in sales last year and net income of $16 billion.

The business that's most often pointed to as Wal-Mart's target with Neighborhood Market is the dollar store, which has used low sticker prices to steal business from the megaretailer since the recession began. The three largest dollar stores had a combined total of $35.7 billion in sales and $2 billion in profit in the last fiscal year and are worth a combined total of $37 billion on the stock market. If Wal-Mart took every single dollar of their business it would add just 7.5% to its total sales and 12.7% to the bottom line.

Source: Yahoo! Finance and company SEC filings.

In short, despite having 24,123 locations, the dollar store industry still does a fraction of the total business Wal-Mart does.

Bigger fish?
A bigger target for Wal-Mart could be the neighborhood pharmacy business because a major offering for the Neighborhood Market will be prescriptions and over the shelf medicine. But this is a business that's firmly controlled today by CVS Caremark and Walgreen. Taking a significant share of this business would have a bigger impact on Wal-Mart as a whole.

Note: Data for CVS Caremark and Walgreen includes pharmacy sales. Source: Yahoo! Finance and company SEC Filings.

This could be a decent gauge of the size of its market opportunity. But Wal-Mart is fighting an ingrained business. CVS Caremark and Walgreen have pharmacy contracts with major insurers and hospitals, as well as convenient locations already up and running around the country. It would take decades to replicate that same business with the Wal-Mart Neighborhood Market.

The grocery store model
Wal-Mart Neighborhood Market could also take market share from grocery stores. Wal-Mart will have its ever-growing number of stores stocked with fresh fruits and vegetables and other food items, which should be a major draw in densely populated regions.

But herein lies a problem: The biggest grocer in the country is... Wal-Mart! And it's not even close. 

Fifty-six percent of the revenue generated at U.S. Walmart and Sam's Club stores came from the grocery segment. That's a whopping $188.5 billion from selling groceries and dwarfs some of the largest grocers in the country. 

Below I've compiled the corresponding location, sales, and net income data for a few of the biggest grocers in the country.

Note: Safeway's results include a $3.3 billion gain from discontinued operations. Source: Yahoo! Finance and SEC filings.

You can see that groceries could actually add significantly to Wal-Mart's sales and income if done right. But with hundreds of competitors in a fragmented market that it already dominates, the company may not add a lot to sales and instead cannibalize larger-format stores where someone might come for a few groceries and leave with a whole cart of goods.

Urban centers are Wal-Mart's target with Neighborhood Market. Photo source: Wal-Mart.

How fast can Wal-Mart grow the Neighborhood Market?
For Wal-Mart Neighborhood Market to be more than a blip in this vast retail empire, the company needs to grow faster than the 270 to 300 stores it plans to open this year. It's a good start, but competitors' store counts reach into the tens of thousands. However, Wal-Mart has the scale to compete in the Neighborhood Market business and to make it a significant share of its business.  

Should investors care about the opportunity in Walmart Neighborhood Market? The concept has been around since 1998 and has been little more than a side project for the company. But with Supercenter store sales falling quarter after quarter, management is looking for a concept that can grow. Wal-Mart Neighborhood Market certainly has that opportunity, but the company would have to take significant share from dollar, drug, and grocery stores without cannibalizing its own business for the concept to be a success. That's a tall order in today's retail environment.

I wouldn't jump into Wal-Mart stock because of Neighborhood Market, simply because it's not a big enough piece of the business now to matter. That may change in three to five years, but Supercenter sales still dominate the company and they're on the decline both at home and abroad. That doesn't bode well for Wal-Mart over the long term, and that's what investors should worry about.