Investors Should Not Ignore This New Trend in Retail

by: NakedValue

The New Retail Profit Growth Strategy

Sales at major US retailers have rebounded from the recession lows on the backs of resilient US consumers. But skepticism over continued consumer strength is growing. On top of that, retailers are facing a dual squeeze. Rising gasoline prices will crimp spending capacity and rising costs of inputs like cotton (cotton has risen +161% in the last twelve months) will cut margins on the products they do sell.

To maintain profit growth in the face of these pressures, many retailers seek a new strategy. Retailers are reconfiguring and often downsizing their stores to increase sales per square foot.

According to the Wall Street Journal’s article, “As Big Boxes Shrink, They Also Rethink,” this phenomenon has gained popularity with many of the US’s largest retailers, including Best Buy (NYSE:BBY), Sears (NASDAQ:SHLD), Gap Inc., (NYSE:GPS) Office Depot (NYSE:ODP), Home Depot (NYSE:HD) and Wal-Mart (NYSE:WMT). For example, at Sears Holdings, the company:

"Is letting prospective tenants browse an online list of Kmart and Sears stores with space to rent. No deal seems too tiny: It let a Rockford, Ill. dental clinic set up shop in two Kmart’s last year, though the venture fizzled after the owner ran into unrelated financial trouble.”

Instead of subleasing existing square footage, Best Buy and Wal-Mart will attempt new concepts with smaller stores. According to the Wall Street Journal article, Best Buy plans to open 150 Best Buy Mobile stores in FY2012 and Wal-Mart plans to open a Wal-Mart Express later this year.

Gap Stores expects to increase sales per square foot by both reducing average store size as well as incorporating previously separate brands back into the same store. In the future, the company plans to close stand-alone Gap Baby and Gap Body stores and reincorporate them into Gap stores. Gap CFO, Sabrina Simmons, said in the company’s latest earnings call that the company expects to remodel and downsize 100 Old Navy’s this year after doing the same to about 200 last year.

Investors Cannot Ignore This New Trend

This new strategy among the largest retailers will have reverberations for the entire industry and investors need to pay attention. The potential winners and losers are not always clear. For example, RadioShack Corp. (NYSE:RSH) and GameStop Corp. (NYSE:GME) are considered companies with the most to lose if the Best Buy Mobile concept succeeds. RadioShack has a trailing P/E of 8.5, a forward P/E of 7.5 and a trailing EV/EBITDA of 3.5. GameStop has similarly cheap ratios with a trailing P/E of 8, a forward P/E of 6.8, and a trailing EV/EBITDA of 3.8. Considering that RadioShack has 4,476 company owned stores and GameStop has 6,450 locations, are these companies being unfairly punished by the 157 store Best Buy Mobile?

It may also be prudent to take a closer look at Walgreen Co. (WAG) and CVS Caremark Corp. (NYSE:CVS). If the Wal-Mart Express and Staples concept stores take off, it could be at the expense of those pharmacy chains.

Some famous investors may be betting on this retail trend. Many market watchers were surprised to see Eddie Lampert’s hedge fund take a large stake in retailer in Gap Stores last quarter. Gap Inc is already a cheap company with a forward P/E of 10.5, but could he have been further enticed knowing the hidden upside in Gap Inc related to a reconfiguration of the stores? Considering his experience at Sears Holdings, it’s very possible that was one of the driving forces of his investment.

Going forward, investors will benefit by looking at the potential winners and losers of this new trend in the retail industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.