Thomas J. Holmes on Wal-Mart's location strategy

Editor's note: Thomas J. Holmes is a professor of economics at the University of Minnesota and a Research Department consultant at the Federal Reserve Bank of Minneapolis. He recently presented a paper titled "The Diffusion of Wal-Mart and Economies of Density" at an applied microeconomics conference at the Minneapolis Fed. The paper follows from a body of his work over the years investigating corporate decision-making based on taxes, location, plant size, trade patterns and other factors. The following interview describes Wal-Mart's location strategy and possible implications for the Ninth District.

fedgazette: Let's begin with a description of the economics of density. How should readers understand the term, especially in light of your work on Wal-Mart?

Holmes: Briefly, Wal-Mart has an incentive to keep its stores close to each other so it can economize on shipping. For example, to make this simple, just think about a delivery truck: If Wal-Mart stores are relatively close together, one truck can make numerous shipments; however, if the stores are spread out, you wouldn't have that benefit. So, I think that the main thing Wal-Mart is getting by having a dense network of stores is to facilitate the logistics of deliveries.

There are other benefits, too. Opening new stores near existing stores makes it easier to transfer experienced managers and other personnel to the new stores. The company routinely emphasizes the importance of instilling in its workers the "Wal-Mart culture." It would be hard to do this from scratch, opening up a new store 500 miles from any existing stores.

fedgazette: This idea leads to another term at the core of your paper, "diffusion path," which I understand to be a description, in this case, of a store's location choices. Please describe Wal-Mart's diffusion path.

Holmes: This is an important point. Wal-Mart started with its first store near Bentonville, Ark., in 1962. The diffusion of store openings radiating out from this point was very gradual. And this diffusion didn't just occur in one direction, but spread out in all directions, with the same measured deliberation. Imagine a slowly blooming flower, or a pebble dropped in a pond, with the waves moving across the water in slow motion. It is very helpful to view a movie [WMV file] of the entire year-by-year diffusion path.

fedgazette: You observe in your paper that Wal-Mart chooses lower-quality sites over more optimal ones. This seems counterintuitive: Why would Wal-Mart engage in such a strategy?

Holmes: Lower-quality is a funny term, and we have to be careful about how we're using those words. If Wal-Mart looks at the whole United States, there are naturally going to be some places that look more attractive than others. We have to take into account that all potential locations are not born equal. Now, if we would rank those sites, what would be the chance that all of the best ones would be in Arkansas or in Missouri, which is where Wal-Mart initially put all its stores? Not very likely.

For the sake of this discussion, let's say that Wal-Mart's most desirable location, or "sweet spot," when it was starting its business was a town the size of 20,000. One strategy Wal-Mart could have pursued would have been to go around the country opening stores in its sweet spot locations and then later go back and "fill in" less desirable locations. With this alternate strategy, the first store in Minnesota would have opened a lot sooner than it actually did, as there certainly are locations in Minnesota right in Wal-Mart's sweet spot. But with this strategy, stores would initially have been much more spread out. Wal-Mart would have lost the gains from having a dense network of stores.

Instead, Wal-Mart waited to get to the plum locations until it could build out its store network to reach them. It never gave up on density.

fedgazette: And when you see what it's done, with the benefit of hindsight, it seems like the right thing to do, almost the obvious thing to do. But that would suggest that other retailers would have also recognized the benefits of density and should have engaged in the same behavior. Did Wal-Mart invent, if you will, this retailing idea?

Holmes: It is useful to contrast Wal-Mart with Kmart, as both opened their first stores in 1962. Wal-Mart, from the very beginning, was different from Kmart. Wal-Mart built up its store network gradually from the center out; Kmart (and Target, for that matter) began by scattering stores all over the country. Early on, Wal-Mart focused on logistics, with things like daily deliveries from its distribution centers, early adoption of advanced communication technology and so forth. Kmart did not do these things. A customer going into these two stores might not be able to see much of a difference between the two stores. But underneath, in the way that merchandise was getting on the shelves, these stores were very different.

But to get to your question: I don't think that Wal-Mart's logistics strategy was appreciated at the time. Its model, now being replicated by others, was a new model.

fedgazette: It would seem that Wal-Mart was confident enough in its retailing product that it wasn't concerned about being late into a particular market; that is, it stuck to its density strategy without leapfrogging to a new sweet spot, even if that sweet spot may have been threatened by a competitor. Is that an accurate assessment?

Holmes: That's almost the way it seems. It knew it had a good product and strategy and perhaps didn't worry too much about other players. But I think it's a bit of an open question about how much Wal-Mart may have been partially preempted in some markets. For example, it may have been a little late getting into Minnesota and the Ninth District more generally, as Target has filled in the area, leaving less room for Wal-Mart. The median person in our district is 6.3 miles to a Wal-Mart, the largest distance across all districts, with the exception of the New York district. Contrast this with the Dallas district, where the median person is only three miles to a Wal-Mart. Of course, the median distance of 6.3 miles here still represents a significant amount of penetration on Wal-Mart's part.

It may have been that by waiting to get to Minnesota until it was able to build up its network to reach it, Wal-Mart gave Target time to preemptively build up its network here. The key thing to note, however, is that if Wal-Mart had done something different—if it had jumped ahead to Minnesota before it had built out its network—it wouldn't have been Wal-Mart. It would have been undercutting the strategy that made it successful in the first place.

fedgazette: Will other retailers be able to effectively replicate Wal-Mart's strategy?

Holmes: Yes, there is opportunity for other companies to
benefit—Target, for example, is benefiting from its own density networks. However, while others may be doing it, there may not be room for a large number of other players, particularly in rural areas.

fedgazette: So let's look at this from a consumer's point of view. Let's say I live in a city of 100,000 people, and there is no Wal-Mart in town ...

Holmes: Actually, I don't think that premise is true. Well, Manhattan doesn't have a Wal-Mart, but there is one right across the bridge in New Jersey. For most people in the United States, a Wal-Mart is literally just down the road. The median distance to a Wal-Mart in the United States is 4.2 miles, and to a Target, five miles. So the typical person doesn't have to go far to shop at either place. Distances are larger for people in rural areas. For example, for those areas of the country with less than 5,000 people within a five-mile radius, the median distance to a Wal-Mart is 14.3 miles, and to a Target it's 34.8 miles.

fedgazette: So what does that mean for the future growth of Wal-Mart? If most consumers are already a stone's throw from a store, where can the company grow?

Holmes: Wal-Mart is mainly growing right now through the grocery business, because it has pretty much saturated the market in its traditional business. This saturation means that Wal-Marts are often competing with themselves. I estimate that there is a fair amount of cannibalization going on when Wal-Mart opens up a store—virtually every new store takes some business from existing stores. In some cases, as much as 20 percent of a new store's sales come from existing Wal-Mart stores.

Having said all this, the company does intend to squeeze in hundreds of more stores in the next few years. And some parts of the country are "under-Wal-Marted." Minneapolis-St. Paul is a good example of that. Maybe because of the presence of Target, maybe because of different demographics, whatever the reason, we are under-Wal-Marted relative to other parts of the country.

If you look at some places in the South, there is literally no room for another store. But what Wal-Mart is doing in the South is adding groceries to existing stores and opening smaller stores that sell primarily groceries called Neighborhood Markets.

fedgazette: So, let's look at the Ninth District in particular. If I live in North Dakota, for example, and I already have my Wal-Mart, and there may not be any more—or many more—new stores being built in my state, what can I expect from the company? Should I expect to see my store turned into a Supercenter that sells groceries and other products?

Holmes: That's a good question. If we look at a map of the Ninth District, we see that most Wal-Marts in South Dakota and Montana are Supercenters, but so far, most stores in North Dakota have yet to be converted to Supercenters. That would suggest to me that grocery stores in North Dakota should be wary. The map and Wal-Mart's past behavior suggest it is only a matter of time before the rest of the Wal-Marts in North Dakota are converted over.