Second Quarter Earnings Review: Where Is Wal-Mart Headed?

| About: Wal-Mart Stores, (WMT)


Wal-Mart continues to feel the pressure from subdued retail spending in the U.S. and growing popularity of smaller stores.

The company’s quarterly sales are ahead of Street expectations while earnings match forecasts.

Higher costs relating to employee health care, compliance and e-commerce investments take a toll on the quarter’s performance, and the company pulls down its full-year guidance.

Key to Wal-Mart’s future success will be returns from its investments in international growth, smaller format Neighborhood Market in the U.S., and e-commerce.

Wal-Mart (NYSE:WMT), the world's largest retailer, reported another dull quarter on August 14 with lackluster sales and earnings performance. It's true that the retail giant exceeded analysts' expectations on the first count and matched estimates on the second, but analysts in any case were not expecting a lot given the company's recent track record. Revenue in the quarter increased 2.8% to $120 billion from $116.8 billion in the year-ago period. Net profit came in at $4.09 billion, a tad higher compared with last year's $4.07 billion. All eyes were on the U.S. store sales that account for nearly 60% of Wal-Mart's top line. While store traffic in the country declined for the seventh straight quarter, the saving grace was that comparative same store sales remained flat. After five straight quarters of comp declines, this wasn't too bad.

The quarter was characterized by high costs relating to compliance, employees' healthcare and investment in e-commerce, among other things. These impinged on the operating income that went down 2.4%. Wal-Mart incurred $43 million FCPA and compliance-related costs. Health care costs increased around $180 million in the quarter compared to the same period last year and were way beyond the company's expectations. This happened because more and more employees signed up for health cover. Going forward also, the management expects this trend to continue and now predicts health-care expenses to surge by more than $500 million for the year. Wal-Mart has been investing extensively in e-commerce as it sees the future of retail in this platform.

All these and more have made the company lower its profit expectations for fiscal year ending January 31 to $4.90 - $5.15 per share from $5.10 to $5.45 per share projected earlier.

U.S. sales unlikely to improve during the year
Wal-Mart has been facing lackluster demand from its consumers that are under pressure because of higher living expenses and low wages. Retail sales stagnated in the country in July, which marked the worst purchase trends in the past six months. Bloomberg quoted Stephen Stanley, chief economist at Pierpont Securities, saying, "There's no sign of momentum or enthusiasm out of the consumer right now."

The growing prices of commodities of daily requirements are creating an air of uneasiness among the buyers. As a result, they are looking out for the cheapest alternatives, and here's where Wal-Mart is feeling the pinch. The smaller dollar stores are able to offer commodities for a few cents less. Instead of driving to big-box Wal-Mart supercenters and stocking up on necessities, people are going to nearby dollar stores for provisions. That way they save not only on the price difference in products but also on gas. Wal-Mart faces the biggest threat in grocery items. In a telephone interview to Forbes, Brian Yarbrough, analyst for Edward Jones, said that grocery chains like Safeway (NYSE: SWY) are also encroaching on Wal-Mart's territory together with the dollar stores as they have figured out the preferences of American buyers.

Wal-Mart CEO Doug McMillon was candid enough to say, "…we wanted to see stronger comps overall in Wal-Mart U.S. and Sam's Club. Stronger sales in the U.S. businesses would've helped our profit performance in the quarter." But, it seems that investors need to wait a while before they are able to see the stronger comps because the company expects flattish comps growth in the third quarter as well.

Wal-Mart's new growth strategies
Wal-Mart is betting on three things to offset the weakness in U.S. store sales - higher international comps, increase in Neighborhood Market comps in the U.S., and e-commerce growth. It's investing heavily in these areas. Though the company's return on investment, according to Bloomberg, has fallen to 16.6%, down from 17.9% a year ago, and the return on invested capital stands at 13.02%, as compared to 14.61% of fiscal year 2011, management is optimistic about future prospects.

International comps: Wal-Mart International's operating income in the quarter went up 8% to $1.5 billion. Every country, except China, reported positive comp sales. Net sales for the segment rose more than 5% on a constant currency basis. David Cheesewright, Wal-Mart International president and CEO said, "We remain focused on price investment across all our markets and expect to continue driving improved comp performance. I am pleased with the trends in many of our markets, which were driven by a continued focus on being the lowest cost operator."

Small-store comps: Wal-Mart's Neighborhood Market comps in the U.S. went up by a decent 5.6% in the quarter with traffic increasing 4.1%, rewarding the behemoth's efforts at growing its presence in the smaller store format. It opened 22 Neighborhood Market outlets in the quarter and plans to launch 180-200 in the year. Wal-Mart is trying to win back consumers by cashing in on the increasing popularity of the small-store concept, and the positive comps growth is definitely good news. Management plans to offer better range of items at better rates, and exceed customers' expectations.

e-commerce growth: In the quarter, Wal-Mart reported 24% year on year growth in e-commerce sales from the four major markets of U.S., U.K., Brazil and China. The e-commerce business contributed approximately 30 basis points to the total Wal-Mart U.S. comp sales growth, and management expects this contribution to improve significantly in days to come. The retail mammoth has been investing quite extensively in its e-commerce infrastructure. In the last three years, the company has acquired 14 e-commerce related companies, including four in 2014, and the CEO has been on record saying that the pace of acquisitions is only going to increase.

Wal-Mart recently launched the updated e-commerce website and management is hopeful that the U.S. customers will appreciate the streamlined search and navigation functionality that the site now supports. The company is also addressing the requirements to make its supply-chain more effective and efficient -- work on a new e-commerce fulfillment center is in progress.

Keep the faith
Wal-Mart's weak quarterly numbers and lowered outlook don't give enough reasons to rejoice, but long-term investors should remember that the behemoth is trying to change with changing preferences of its customers. Making a shift from being an in-store retailer to an online retail giant doesn't happen overnight and it calls for huge financial commitments. Same thing can be said about the Neighborhood Market and international expansion. Wal-Mart is trying to pull down costs to offer better prices and variety of products to both in store and online customers. As the company starts reaping results from the new initiatives, it could gradually improve returns, and please the investors better.

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