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Retail giant Wal-Mart (NYSE:WMT) has been pushing into the financial services market lately. The company already operates retail banking businesses in Canada and Mexico. In the US, one of the most recent initiatives include a program that allows U.S. small business owners to apply for commercial loans through the company’s Sam’s Club stores.

Wal-Mart competes with Costco (NASDAQ:COST) and others in the U.S. retail market. But profit margins are much higher in financial services than in retail. And Wal-Mart has a significant opportunity to grab share in the U.S. retail banking market given that traditional banking institutions lost significant credibility during the recent financial crisis. Our analysis follows below.

Wal-Mart at the gate

Wal-Mart has been trying to get into the financial services business for several years now. Due to fierce opposition from the U.S. banking industry, Wal-Mart was forced to withdraw its U.S. bank charter application in 2007. However, Wal-Mart launched retail banking units in Mexico in 2007 and recently obtained Canadian government approval to operate a banking business there.

We estimate that Wal-Mart’s cash profits (net of all expenses) are about 3% of its revenues.[1] Its potential profit from financial services is several times larger than that. As a result, Wal-Mart’s gross margins could improve if financial services made up a larger proportion of its revenues. We currently expect Wal-Mart’s gross margins to remain at around 27% during our forecast period. You can drag the trend-line in the chart above to create your own gross margin forecast and see how it impacts the company’s estimated share value.

In line with Wal-Mart’s reporting structure, we account for financial service revenues under the “Membership & Other Income” division. These revenues could increase if Wal-Mart expands into banking aggressively, thus creating additional upside for the stock. In the next interactive chart you can drag the trend-line to create your own membership and other income forecast and see how it affects the stock.

Goodbye Wall Street, hello Wal-Mart

The recent economic crisis badly shook U.S. consumer confidence in traditional retail banks. In a recent survey conducted by J.D. Power & Associates, the proportion of consumers who definitely did not plan to change banks within a year fell from 46% in 2007 to 34% in 2010 [2]. The survey showed that consumers increasingly perceive banks as institutions that care more about profits than about their customers.

By expanding into banking, Wal-Mart is trying to create a one-stop destination where customers can satisfy their financial and material needs. If consumers perceive Wal-Mart’s banking to be valuable, they may also increase their purchases at Wal-Mart stores.

Wal-Mart’s enormous scale allows it to cut costs and pass the savings on to customers. Accordingly, its brand image is strongly associated with cost savings and value. This image could help Wal-Mart gain banking customers for its banking business.

Moreover, at least some of Wal-Mart’s U.S. customers either lack access to mainstream financial services or don’t use them regularly. Wal-Mart could potentially tap into this customer base by offering them proprietary financial services.