Wal-Mart vs. Target

I seem to be writing a lot about Wal-Mart recently–and I’ll end up doing it again here.

I’ve surprised myself a bit over the past few weeks by concluding that owning shares in the company ends up giving you better risk characteristics than holding a government bond, while providing comparable income and higher reward.  The more I think about this, the more convinced I become that it’s true.

As an equity investor, on the other hand, I should point out that WMT has outperformed TGT by about 40 percentage points over the past year.  This is a huge amount.  I suspect that this relative performance will at least partially reverse itself in the year to come.  This is only secondarily because the performance differential between the two is so great.  My primary reason for thinking this is that in a recovering economy during 2010, current WMT customers will trade back up again to TGT.  Yes, I still think the overall pattern of consumption will be biased toward trading down.  I think customer migration upward from WMT to TGT will happen, and will be an exception.

Our starting point:  the department store

Anyway, let’s take, as our starting point for this brief sketch of retail, the department store of the Seventies.  A mid-nineteenth century phenomenon, the department store remained conceptually pretty much unchanged for over a century.  Its characteristics are:

–merchandise organized by type in “departments,”

–fixed price,

–exchanges allowed,

–large selection within departments,

–large number of departments (one-stop shopping),

–urban location.

Although fixed price and exchanges may have been innovations at one time, the main attractions for a shopper today are, I think, the large array of merchandise at one location, plus the store’s reputation for a certain level of quality and for a reasonable price.

The rise of specialty retailing

In the Seventies, two related developments began to undermine the department stores:

1.  the move to suburbs.  Customers became more widely disbursed geographically and less enthusiastic about travelling into the urban center for shopping.

2.  the rise of specialty retail.  Not all departments in the department store are equally profitable nor can all offer an equally well-selected array of merchandise.  These characteristics gave entrepreneurial retailers the idea of building chains of smaller suburban stores whose sole focus would be to compete against a single, high-margin department in the department store.

The main selling points of specialty retail:

–wider/more attractive selection than the “department” being attacked

–lower real estate costs

–closer physically to the customer

–could also compete successfully with local mom and pop stores

–possibility of becoming a very big national chain.

In addition, because the US covers such a large geographical area, and has a relatively large and relatively affluent population, a budding national specialty retailing chain could expand for many years before saturating the market, or even encountering serious non-department store competition.

There many now-famous retailing names, from The Limited and Gap to Victoria’s Secret, that have followed this path to success in women’s apparel.  But the assault on department stores wasn’t limited to clothing.  Toys R Us, Bed Bath & Beyond, and Best Buy are just a few of the successful specialty retailers whose revenues came from taking customers from the department stores.  Yes, they all competed against mom and pop stores, as well as not-so-successful rivals like Child World, Linens N Things or Circuit City. But the low-hanging fruit was the department store customer.

A specialty retailing strategy is not risk-free

This is not to say that simply targeting one area of the department store was a sure-fire road to fame and riches.  The last three companies mentioned all fell victim to stronger competitors in the specialty retailing arena.  The final two hung in for a relatively long time; Child World folded relatively early in the game.

Speaking in the most general terms, the department store offered a very wide range of merchandise but not a very deep assortment of items in any one department.  The majority of its offerings had to be generic, or maybe “bland” enough to appeal to a wide span of potential customers.  Specialty retail, in contrast, offered a narrow range but a wide assortment.  Any one specialty concept may have focused on a relatively narrow demographic.

Specialization carries its own risks.  One of the first examples of this that I encountered personally was a company called Fotomat, which I covered as an analyst until it was taken over by Konica.  (Although not strictly speaking a competitor with department stores, the company is a useful illustration of the general point.)  Fotomat operated small kiosks in the parking lots of malls.  It used the kiosks to collect film shot mostly by 110mm point-and-shoot cameras, developed it in central labs overnight, and returned the prints and negatives to customers the following day.  Talk about specialization!

What happened to the Fotomat business?  It didn’t succumb to changing technology in photographs–it didn’t last that long.

In the early Eighties, drug store chains, which had stores in many of the same malls where Fotomat had kiosks, began to offer film developing services as a loss-leader to build foot traffic in their outlets.  In other words (sorry if I’m beating the point to death), if it cost $8 to develop and print a roll of film, the drug store would charge $6.50, figuring that the film customer would buy enough other stuff in the store that the overall transaction would make a profit for it.  Fotomat, in contrast, had nothing else to sell and had to charge, say, $10 to cover its other costs and break even.  Q:  Who would be willing to pay Fotomat $10 for prints when the identical service was available for $6.50 just a few steps away?  A:  Not that many people. Fotomat tried to figure out something else to sell in its kiosks, but they were too small.

That’s enough for this post.  I’ll return to the vulnerabilities that “overspecialization” creates in my next post, about the emergence of the national discount chains, Wal-Mart, Target, and K-Mart.