"Industry Insight" is a weekly series that examines sectors through what's known as the five forces of competition, which can help separate the winners from the losers. Come back every Monday to see which industries and companies will be put under review.
BENTONVILLE, Ark. (
) -- They may be ugly but big box-stores like
BJ's Wholesale Club
aren't going anywhere.
While many expect Web commerce to render brick-and-mortar retailers obsolete, these chains have been hedging their bets and expanding their presence online. If you size them up based on the five forces of competition concept developed by Michael Porter of Harvard Business School 30 years ago, you'll find a strong investment case.
Performance in this sector has been weak with only Target beating the broader market this year. However, these companies' stocks are cheap, with price-to-earnings ratios that are less than the industry average.
Degree of rivalry:
Price cuts and convenient locations are the most potent weapons for competitors in this space. While prices wars can reduce margins, much of the pain is spread to suppliers that can't afford to not do business with stores like Wal-Mart and Target.
It's not uncommon to Wal-Mart and Target stores separated by only a few hundred yards on a commercial road. The ability for these stores to survive even with tight grouping is proof that massive discounts are less important than overall sales volume.
Last year, Wal-Mart had more than $405 billion in sales, an operating margin of 5.6% and a profit margin of 3.3%, versus an average operating margin of 6.1% for all retailers and a profit margin of 1%. The company's size allows it to spread costs more efficiently, allowing it to make money despite the thin profits it reaps on individual items. This makes it more difficult for smaller operations to compete.
Bargaining power of customers:
These stores are so prolific that comparison shopping is simple, which makes competitive pricing extremely important. Even though price cuts erode margins, they impact the profits of large chains less than they do for specialized retailers.
Bargaining power of the suppliers:
Wal-Mart operates more than 3,600 stores in the U.S. alone. Missing out on Wal-Mart's massive customer base is a serious handicap, so most companies accept Wal-Mart's terms regardless of how painful they might be.
In the late 1990's, Wal-Mart started selling Vlasic pickles in one-gallon jars for $3 each. Both companies were making pennies on each sale, but jars were selling so fast that Wal-Mart demanded to keep the sale going, despite the damage it was causing Vlasic. If Vlasic had resisted, it could have lost Wal-Mart's business. Sales of gallon jars quickly devoured sales of more profitable Vlasic products and created a shortage of pickles, devastating Vlasic financially. Eventually, Wal-Mart relented but the situation shows how much power suppliers have: zero.
While it may not be to the same degree, Target has similar clout. Without the big retailer's shelf space, some products could vanish completely. This bargaining power helps the chains keep supply costs down, boosting profits despite low prices.
Threat of new entrants:
It takes a long time for a chain to become large enough to generate sales that can sustain deep discounts. Basic store logistics add costs that need to be covered by the prices of products. For that reason, new entrants will likely come in the form of established stores that decide to move into areas dominated by big-box stores. For example, department-store chain
offers products like clothing and housewares, but lacks food and electronics. If Kohl's were to add those segments, it could create a formidable new rival; however, this is unlikely for now.
Threat of substitutes:
Online retailers such as
may be able to compete with the big chains on price, but simple logistics will keep them from replacing big-box stores. For customers looking to purchase a patio set from Wal-Mart or bulk paper towels from Costco, shipping these items is very inefficient. The same can be said for products with short shelf lives and smaller items that cost less than shipping them.
Wal-Mart, Target, Costco and BJ's have also developed strong Web sites, allowing them to cater to customers that prefer to shop online.
With consumer spending down and unemployment up, many investors are avoiding retail stocks. However, they're good holdings in most economic situations. In fact, we rate these companies "buy." It's a good time to look at the industry and pick up some bargains.
-- Reported by David MacDougall in Boston
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Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.