How Wal-Mart's Margins Could Be Squeezed by Rising Chinese Manufacturing Costs

| About: Wal-Mart Stores, (WMT)

Wal-Mart (NYSE:WMT) is the world’s largest retailer, with more than $400 billion in store revenues in 2009. Major competitors include Costco (NASDAQ:COST), Target (NYSE:TGT) and Best Buy (NYSE:BBY). Wal-Mart offers consistently low prices in both its retail stores and warehouse clubs.

The value of China’s currency, the yuan, has crept upward recently as the Chinese government moves to delink it from the U.S. dollar. As a result, Chinese export products have been growing more expensive. At the same time, Chinese labor shortages have led to wage hikes and increased manufacturing costs. Both trends are worrying to Wal-Mart, which sources many of its products from Chinese manufacturers.

Below we explain how these developments could squeeze Wal-Mart’s profit margins and put pressure on its stock value.

Wal-Mart imports many products from China

In 2006, Wal-Mart imported about $27 billion of inventory from China. In 2006, Chinese products accounted for approximately 7.8% of Wal-Mart’s total sales. If Wal-Mart were a country, it would figure in China’s top 10 export destinations. And several of Wal-Mart’s non-Chinese suppliers operate manufacturing units in China, giving Wal-Mart additional indirect exposure to China’s economy.

Yuan appreciation and wage inflation could increase Wal-Mart’s cost of goods

The People’s Bank of China recently announced plans to make the yuan more flexible in an effort to aid global economic recovery . Chinese authorities intend to weaken the yuan’s two- year-old peg to the U.S. dollar, which had come under intense international criticism because it made Chinese exports artificially cheap. This means that Wal-Mart will have to pay more for the goods that it imports from China, which will squeeze its gross margins.

At the same time, China is facing a severe labor shortage that has been driving wages upward. According to the Institute of Contemporary Observation, turnover in some low-tech industries is approaching 50%, and companies all over China are having trouble filling empty positions. Local manufacturers must pay higher wages to attract talent, putting pressure on their margins. For example, Yongjin Group, which sells lamps and furniture to Wal-Mart, has increased its wages by 40% over the past year. It’s only a matter of time before Yongjin and other Chinese manufacturers start passing these costs on to customers like Wal-Mart.

A 3% rise in the yuan could reduce Wal-Mart’s gross margins by 20 basis points

Assuming that Wal-Mart continues to import about 7% of its sold inventory from China, a 3% rise in the yuan could increase Wal-Mart’s cost of goods sold by $900 million. All things equal, this would reduce gross margins by approximately 20-25 basis points. And if Chinese producers pass on their increased manufacturing costs to Wal-Mart as we expect, the company’s gross margins would be reduced by an equivalent or greater amount. You can adjust the chart below to see how changing gross margins impact Wal-Mart’s stock.

Disclosure: No positions