Wal-Mart’s Holiday Discounts: Revenue at the Expense of Earnings

Wal-Mart (WMT) announced major price cuts in advance of the Christmas Holiday season, as part of an effort to boost sales during what is likely to be a difficult holiday shopping season for retailers. Whilst it’s likely that the retailer’s cheaper toys may lure buyers away from other retailers, it doesn’t change the fact that Wal-Mart is sacrificing earnings to generate revenue growth. I anticipate seeing the following scenario with Wal-Mart during the holiday shopping season: they’ll report solid same store sales due to the deep discounts and investors will send the stock price up, followed by a disappointing earnings report which sends the stock price back down.

The movement in Wal-Mart’s stock price from their use of deep discounts to drive sales has become quite predictable, it’s been a dependable pattern for a couple of years running, with the most recent occurrence being this past summer.

Many in the media will anticipate a “response” of some sort from Target (TGT), Wal-Mart’s alleged competitor, but don’t expect Target to jump on Wal-Mart’s deep discount bandwagon. Whilst there is some overlap between the two retailers, Target and Wal-Mart aren’t really competitors due to the fact that each retailer has different customer demographics and compete for customers in diametrically opposed fashions. Target competes for customers based on brand, style and cachet, whilst Wal-Mart competes on price, and Target’s customers out earn Wal-Mart’s by about $20k+/yr. Meaning, Target will probably only try to match Wal-Mart on a few items, whilst sticking to their tried and true formula of selling the Target brand.

Wal-Mart needs a new strategy to drive sales, as revenue growth at the expense of profit growth isn’t the answer. Looking at the retail sector as a whole, I anticipate seeing declines across all retailers even up-market ones like Nordstrom (JWN), as consumers who used home equity and credit cards to “spend-up” may not be shopping at high priced retailers this holiday season. Target may be uniquely positioned to benefit from a consumer spending slow down due its “affordable luxury” brand strategy, customers who may not be able to afford to spend up-market, are going to be more willing to “spend down” with Target than at Wal-Mart.

The other aspect of this situation that warrants discussion is the fact that the majority of Wal-Mart’s discounts are centered on toys, and we all know that the bulk of Wal-Mart’s toys were made in China. It’s quite possible that some consumers may avoid Wal-Mart all together due to fear of purchasing a dangerous product, due to all of the recent recalls of Chinese made products. The “made in China X-factor” is something that can’t be ignored when it comes to Wal-Mart’s holiday sales.

Disclosure: The author doesn’t own positions in Wal-Mart, Nordstrom or Target.

Comments

[logicalsinger:]

Price cuts do not always result in earnings deterioration. If the additional volume from the price cuts is large enough, earnings will be ok even if profit margins fall somewhat. For a company like Wal-Mart, there are some externalities as well when shoppers, who come to the stores to buy the discounted toys, also wander off into other aisles and buy other non-discounted goods.

2007 Oct 08 08:19 AM

[Markham Lee:]

Price cuts create two separate scenarios:

Scenario One) The consumer with a limited amount of available funds, spends the same exact amount of money, but is now able to buy more goods than before. In this scenario, you don't really see earnings growth as the retailer sells more goods for the same amount of money, as they would've if they had left prices alone.

I.e. 15 Widgets for $X vs. 10 widgets for $X

2) A greater number of customers spends money at the retailer, so you "make it up in volume".

I content that Wal-Mart is basically selling 15 Widgets for $X instead of 10 for the same amount, there is "some" volume increase with respect to the number of customers, but overall, it doesn't really generate earnings growth. If recent history is any guide, I suspect this scenario one will be one reflected in WMT's Q4 earnings report.

2007 Oct 09 04:38 AM