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 (NYS: 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 (NYS: 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, (NAS: 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.

At the time thisarticle was published Fool contributorAndrew Marderdoes not own any of the stocks mentioned in this article. The Motley Fool owns shares of and Tesco.Motley Fool newsletter serviceshave recommended buying shares of Tesco and Fool newsletter serviceshave recommended creating a diagonal call position in Wal-Mart Stores. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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