Wal-Mart (NYSE:WMT) ranks among the best corporate growth stories of the past half century. For most of its history, Wal-Mart has been on the cutting edge of retail, constantly pushing the envelope. But 45 years after going public, the company was reacting to change rather than creating it. Not only did its online presence badly lag the competition, but also its physical stores were widely perceived as a lousy place to work and shop. As revenue declined for the first time in recent memory, the stock price plunged from a high of $90 at the beginning of 2015 to just $57 by October.
In retrospect, that was probably a buying opportunity. Even for a guy like me that dislikes Wal-Mart both for the poor shopping experience and the effect on society, I am surprised at how far the massive company has come in just a few short years. Despite widespread skepticism of Wal-Mart’s future in the age of Amazon (NASDAQ:AMZN), the chain’s recent improvements and its fundamental strengths position the retailer to endure for the foreseeable future. That said, considerable doubt remains as to Wal-Mart’s ability to thrive instead of merely survive.
Wal-Mart: A History of Innovation
At one point, Wal-Mart stood at the cutting edge of retail innovation. Remember how video games used to come packaged in a nice cardboard box? I still have some of them in my basement - relics of an era before the “Wal-Mart effect” shaped the industry.
For the manufacturers, the boxes stood out on the shelves and made their products more visible. But Wal-Mart long ago recognized the inefficiency and stupidity of essentially selling air. The packaging materials cost money, and the additional weight and space on the pallet added to shipping expenses. If Wal-Mart could force the companies to eliminate the money spent on cardboard, then they could then split the savings with the supplier and plow their share of the proceeds into lowering price. Plus they could cram more games on the shelf, thus driving sales per square foot. A penny saved on a stick of deodorant sounds like nothing, but when you sell millions a year it starts to add up.
Wal-Mart also disrupted supply chain management by concentrating on rural and suburban America, then an underserved market. The company expanded by opening a distribution center and then saturating the surrounding region with stores. Larger rival Kmart, meanwhile, stretched itself thin by opening stores across the country far away from warehouses. Crucially, Wal-Mart also implemented a sophisticated inventory tracking system. Technology enabled Wal-Mart to figure out that women preferred to buy laundry detergent in a box both small enough for them to carry into the house and large enough to last a week. Kmart failed to adapt and continued selling detergent in gigantic containers.
What Went Wrong?
As the Great Recession roiled the economy, Americans flocked to the chain known for its “everyday low prices.” As a result, Wal-Mart actually enjoyed strong growth in both sales and profit as other retailers suffered. The stock price held up fairly well throughout, and by 2015, it had doubled the S&P 500’s gains since the start of 2007.
Then something extremely unusual happened - Wal-Mart’s revenue started to decline. Probably the biggest reason for this about-face was that with the economy improving, consumers no longer felt compelled to spend their money there. Indeed, other discounters that grew rapidly during the Recession such as Dollar Tree (NASDAQ:DLTR) and Dollar General (NYSE:DG) have since fallen on harder times.
But beyond the changing macroeconomic environment, Wal-Mart was slipping on several fronts. Underpaid and overworked employees created a shopping experience widely seen as subpar, even by Wal-Mart’s executives. According to one internal survey, just 15 percent of stores met the company’s criteria for customer service. Meanwhile the retailer struggled to get its website off the ground, and in the first quarter of fiscal 2017, its e-commerce sales growth only managed a pathetic single-digit increase.
A Mexican bribery scandal revealed in 2013 further embarrassed the company, and CEO Mike Duke was eventually replaced after his role in the fiasco came to light.
Mounting a Comeback
New Wal-Mart chief Doug McMillon, who took the job at age 48, quickly recognized that the company needed to get back to its roots. The company raised hourly wages across the board by an average of 15 percent, and stores also received a facelift. Now 75 percent of Wal-Mart's stores meet the company’s standards for customer service as opposed to the previous 15 percent. When I first ventured into a recently opened Wal-Mart in Saugus, MA, it was like stepping into another chain altogether. Skylights bathe the store in natural light (saving on electricity) and the clothing racks stand atop wooden floorboards. Displays look attractive, and I noted that the produce section was fully stocked with fresh-looking product, which was previously a rarity. The bakery, a high-margin section for grocery, was filled with yummy-looking sweets.
Wal-Mart has also made remarkable improvements to its online operations. After buying startup e-commerce firm Jet.com, Wal-Mart hired founder Marc Lore to turn around its struggling online division. Early results of this acquisition look promising, as Walmart.com sales surged 63 percent in the first quarter of 2018. It also abandoned the ShippingPass program designed to compete with Amazon Prime. The decision to expand free two-day shipping to certain purchases over $35 represents a return to Wal-Mart’s “everyday low price” roots and a move away from a poor imitation of Amazon. As for logistics, the company is testing a creative plan to hire its own workers as last-mile delivery drivers, reasoning that they can cover most of Wal-Mart’s territory during their commutes home. There are also the much-publicized giant grocery vending machines, as well as Lore’s vision of tracking customers’ most frequent purchases via app.
Two competitive advantages position Wal-Mart to survive the Amazonian invasion. The first is that it dominates poor and middle-class consumers in rural and suburban America. This strategy is the exact opposite of Amazon’s approach, which benefits from recent growth in rich urban centers where its business model works best.
Here we can see that Wal-Mart has only few stores around Boston’s outskirts, and no stores in the city itself. Instead they are concentrated in working-class suburbs such as Saugus and Lynn, as well as poor cities to the north like Lawrence and Lowell. The stores appear spread out, but remember that 90 percent of Americans live within 15 minutes of a Wal-Mart.
The second advantage is Wal-Mart’s buying power. The company could be described as what economist Joan Robinson termed a “monopsony,” where one buyer captures enough of a consumer market to effectively control suppliers. To stay in business, many producers simply have to sell to Wal-Mart. For example, Church & Dwight (NYSE:CHD), the producer of Trojan condoms, Arm & Hammer, and a variety of other products, discloses the following in its 2016 annual report:
In each of the years ended December 31, 2016, 2015, and 2014, net sales to the Company’s largest customer, Wal-Mart Stores, Inc. and its affiliates (“Wal-Mart”), were 24%, 24% and 25% respectively, of the Company’s consolidated net sales. No other customer accounted for 10% or more of consolidated net sales in the three-year period.
Similar situations can be found across the board for consumer products companies. Wal-Mart’s size allows it to exercise considerable leverage over suppliers, and it frequently demands (and receives) price decreases. Indeed, the company’s renewed focus on providing the lowest prices has caused grocery prices nationwide to plummet to the lowest level seen in years.
A Challenging Future
The company’s renewed focus on putting the customer first and leading innovation makes me cautiously optimistic about Wal-Mart’s future. Still, investors in retail must practice constant vigilance. It is an interesting business, but also really difficult to forecast. Nobody would have predicted in 1970 that the venerable Sears (NASDAQ:SHLD) and Kmart, which once dominated shopping, would be close to bankruptcy 50 years later. Sears, too, tried to pursue change during the 1990s, and for a few years, it seemed to work. Revenue held steady and even increased slightly, but executives simply could not prevent the disaster unfolding right in front of their eyes.
Since Amazon’s business model works best for urban and affluent consumers, I think it would take a monumental effort to steal away the core Wal-Mart shopper. But then again, conventional wisdom once held that Wal-Mart would not be able to penetrate territory outside of its rural strongholds.
The invasion of German discount grocery chains Aldi and Lidl may be even more frightening than Amazon since grocery accounts for more than half of Wal-Mart’s sales and drives frequent visits. Just a few years ago, British discount giant Tesco (OTCPK:TSCDF) [LON:TSCO] appeared inevitable, but competition from Aldi and Lidl coupled with management hubris caused both profit and share price to crater.
So considering the current competitive landscape, are Wal-Mart's shares a buy? At 17 times earnings, Wal-Mart stock is less expensive than the market average but not exactly cheap. I think the jury is still out on the question if Wal-Mart’s expensive investments in lower prices and e-commerce will actually work. There is a difference between thriving and merely surviving, which is what many investors fail to consider. The former produces market-beating returns while the latter does not. Right now, I am not a buyer, but I might pull the trigger if the company can show that its turnaround can translate into growing profits.
Disclosure: I am/we are long CHD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.