When Cost Plus (NASDAQ:CPWM) showed up on the Watch List in the July issue of Motley Fool Hidden Gems, my immediate thought was, "Cost Plus isn't a Hidden Gem. I drive past its headquarters all the time." But If I'd lived in Arkansas in the 1970s, I probably would've thought Wal-Mart was a well-known commodity, too. After all, the Waltons already had six stores in the tri-county area.

Fortunately, I've learned that "Hidden Gem" doesn't mean "totally unknown." So I brewed a pot of gourmet coffee (purchased at Cost Plus World Market) and took some time to learn more about my neighbors.

Riches in niches
Cost Plus has been in the retailing business for more than 40 years, but its life as a public company started in 1996. Since going public, the company has undergone an aggressive expansion campaign, growing the store count by roughly 20% per year to its current population of 246 stores operating under the "Cost Plus World Market" and "World Market" names. Its retail niche is the unlikely combination of upscale home furnishings and consumables. Home furnishings such as furniture, dishes, pillows, wine racks, and cooking utensils are responsible for slightly more than 60% of sales. The remaining 40% of sales come from a broad selection of wine, microbrewed beer, imported olive oil, specialty foods, and the aforementioned gourmet coffee.

Margins are decent, but not as high as they could be because both segments are fiercely competitive. Home furnishings competes with Bed Bath & Beyond (NASDAQ:BBBY), Williams-Sonoma (NYSE:WSM), Crate & Barrel, Target (NYSE:TGT), and Pier One (NYSE:PIR), another Watch List contender. The consumables business competes with everyone from Trader Joe's and Wild Oats (NASDAQ:OATS) to the local Safeway (NYSE:SWY).

The problem of growth
With success in markets from Oakland to Omaha, sales increasing at nearly 15%, and housing-market mania driving home furnishings, Cost Plus should be on a roll. Instead, growing pains have gnawed into recent earnings reports.

The company's 2004 profit margins were its lowest in five years, and same-store sales grew an anemic 0.9%. Inventory has been growing faster than sales -- suggesting that Cost Plus may be missing the mark with some of its merchandise. Same-store sales also decreased by 1.9% in the first quarter and inventories continued their dangerous climb. Its cash position has declined to $3.7 million and debt, while modest, is increasing. To top it all off, Murray Dashe, the CEO who was at the helm during most of the recent expansion, left the company earlier this year. Former director Danny Gurr has been acting as interim CEO for the past several months.

This continued instability has kept many investors on the sidelines. The stock has been on a steady descent, falling from a high of $48 in 2003 to $23 per share today. Yet despite these recent challenges, this is a story worth watching.

Waiting for a Watch List promotion
The World Market concept has been successful nationwide, and current problems are hardly insurmountable. The addition of 35 new stores in 2005 (minus the closing of five stores) should continue to drive growth on the top line. Cost Plus believes there is opportunity for at least 600 additional stores, so plenty of growth potential remains. Share count has remained stable for the past several years, and as I can personally attest, the corporate headquarters are modest at best -- a classic Peter Lynch indicator of responsible management.

But as Bill Mann noted when he placed the company on the Motley FoolHidden Gems Watch List, World Market has some issues to clear up before it would get the nod as a formal recommendation. Of course, a price-to-earnings ratio (P/E) of 19 doesn't put Cost Plus in the bargain bin, but it's easy to see how the solution of one issue -- inventories -- goes a long way to solving the other.

This $500 million company competes with multibillion-dollar giants (such as Bed Bath & Beyond), which means that it has to execute better on the back end to match what is a compelling retail product. But there's outsized potential in small-cap investing -- potential that Fool co-founder Tom Gardner helps investors realize every month in the pages of Motley Fool Hidden Gems. From the Watch List to the Tiny Gems to the two formal recommendations, subscribers are given seven stock ideas worth looking into and -- more often than not -- buying.

If you'd like to look under the Hidden Gems hood, Tom is offering a 30-day free trial. Simply click here to learn more.

Foolish final thoughts
As for Cost Plus, uncertainties regarding profit margins, inventories, and senior management are a big question mark for this Fool. These issues will need to stabilize before I consider moving Cost Plus from my neighborhood into my portfolio.

Robert Aronen owns shares of Wal-Mart, but none of the other companies mentioned in this article. But in the interest of full disclosure, he wants folks to know that he buys his Bonne Maman jam at Cost Plus. The Motley Fool has a disclosure policy.