May 1 (Bloomberg) -- Wal-Mart Stores Inc.’s bribery probe in Mexico poses a potential threat to growth in its international operations, putting more pressure on the company to execute its nascent small-store strategy in the U.S.
The world’s largest retailer is chasing consumers quite unlike its traditional customers. One is Kelli Janczewski, a 32-year-old health provider relations manager at Humana Inc.’s Chicago office, who last month popped into a Walmart Neighborhood Market in Chicago and grabbed a healthy frozen meal, bananas and discounted candy left over from Easter.
Wal-Mart wants to appeal to urban dwellers like Janczewski by creating the same appeal in cities that it has in its traditional markets in suburbs and towns and tap a market of $80 billion a year. To get started, Wal-Mart will open as many as 100 Neighborhood Markets, though it has tried the small store strategy before without much to show for it.
“That’s always the big question with Wal-Mart: ‘Can they get the next phase of growth with smaller stores?’” said David Abella, senior portfolio manager with New York-based Rochdale Investment Management, which has 38,000 Wal-Mart shares in one fund. “With Supercenters, they have pretty well saturated the market.”
U.S. agencies are probing Wal-Mart and the company is conducting its own review after the New York Times reported April 21 that Wal-Mart’s Mexican unit paid more than $24 million in bribes to open stores more quickly. The investigations could prompt executive departures and U.S. penalties and may slow Wal-Mart’s expansion in Mexico and other markets.
The allegations of a coverup in Mexico yesterday prompted leaders of New York City’s pension funds to say they’ll vote their company shares against the five Wal-Mart directors who are standing for re-election at the company’s annual shareholder meeting next month, New York City Comptroller John C. Liu said today in a statement.
Wal-Mart’s smaller stores are about one-fifth the size of its big-box locations. After years of disappointing results at its small shops, Wal-Mart has lowered costs, boosted sales and produced better margins at its Neighborhood Markets stores, setting the stage for expansion.
Wal-Mart, based in Bentonville, Arkansas, still relies heavily on its 3,029 Supercenters for most of its profit. With plans to add as many as 150 more this year, there is still room for Supercenters to gain market share, said Deisha Galberth Barnett, a Wal-Mart spokeswoman.
Still, the push into smaller stores represents a fresh source of revenue. It could also take market share from grocery and drugstore chains and defend Wal-Mart’s turf from dollar stores such as Dollar General Corp.’s, said Bryan Gildenberg, an analyst with London-based Kantar Retail. Dollar General plans to open 625 new stores this year, according to Bloomberg Data.
Wal-Mart has found out how to make Neighborhood Markets more profitable since starting them in 2000, said two people familiar with the project. In the early years, the net margins for the Neighborhood Markets stores were about 1 percent. Some of them failed and closed. Now they make about 3 percent. Supercenters produce about 5.5 percent net margins, said the people, who asked not to be named because the information is private.
Along the way, Wal-Mart has learned a few things. The early Neighborhood Markets were more expensive to build. Wal-Mart overspent on decor, with touches such as terracotta pots out front and Tuscan-style entryways. The stores also had equipment like photo processors and refrigerators and freezers sized for a Supercenter. All of that resulted in unnecessary spending, the people said.
As the company opened more stores, it spent less on decor and equipment to lower capital costs, the people said.
Wal-Mart also examined how it accounted for profits at the stores. The company had been booking profits for prescription drugs sold at Neighborhood Markets at the regional level, so the income went to corporate profit. In May 2010, Wal-Mart started looking at drug profits on a store-by-store basis and concluded that Neighborhood markets performed better than they had thought.
Wal-Mart declined to comment on capital spending or accounting at the store level. The company has seen better results from Neighborhood Markets, Galberth Barnett said. The stores have produced “significant improvements in operating performance over the last two years, with strong returns,” she said in an e-mail. Neighborhood Markets have boosted same-store sales in the past “several quarters,” she said.
At an investor conference in March, Wal-Mart Chief Financial Officer Charles Holley said that Neighborhood Markets have “about the same return of a new Supercenter.” He also said that same-store sales for Neighborhood Markets grew 5 percent last year. That compares to same-store sales growth of just 0.3 percent at Wal-Mart’s U.S. stores, according to company regulatory filings.
Neighborhood Markets benefit from focusing on food, where Wal-Mart is strong. Meanwhile, Wal-Mart is losing ground in general merchandise to the likes of Amazon.com Inc. Since 2008, Wal-Mart’s grocery sales have risen an average of 5.4 percent a year to $145.3 billion in 2012 and now account for 55 percent of U.S. sales. During the same time, sales of general merchandise have fallen every year.
“Wal-Mart has learned to run Neighborhood markets more effectively,” Gildenberg said. “They found the right mix of food and non-grocery.”
Wal-Mart will find that some products are increasingly sold online and shrink some Supercenters, Gildenberg said. Meanwhile, some Neighborhood Markets may add products in certain areas and get bigger, so the line between Supercenters and small-format stores starts to blur.
Other retailers have looked to cities for growth, or are pushing smaller stores. Home Depot Inc. opened its first store in Manhattan in 2004 and a second one later that year. Both are still open. Wal-Mart rival Target Corp. plans to open as many as 20 smaller-format stores this year in a similar play to Wal-Mart’s move.
Wal-Mart’s share of its core market is between 9 percent and 10 percent, according to Kantar Retail. If Wal-Mart can match that in cities with its smaller stores, the company could grow by $80 billion in the U.S., according to research from UBS AG.
“Wal-Mart is looking into the future, and eventually the big box retailer market will be saturated -- then what?,” said Cameron Smith, president and CEO of CSA Recruiters, an executive search firm in Bentonville that works closely with Wal-Mart’s supplier network.
That’s question investors are asking. Wal-Mart’s stock has declined 1.4 percent so far this year, compared to an 11 percent gain in the Standard & Poor’s 500 Index.
“It’s hard to move the needle,” Abella said. “The core Wal-Mart investor doesn’t believe it yet.”
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