Walmart's Low Price, High Volume Business Model To Face Inflation Challenge

Summary

• Walmart's profit margins have been on an eroding path for some years, even as revenue volumes have been increasing. Merchandise inflation may become a factor that could erase profits altogether.
• Because Walmart relies more heavily on low-income customers, it will be harder to pass on higher merchandise costs compared with the competition.
• If inflation will prove to be transitory, Walmart's healthy financial situation will prevent long-term consequences from arising. Global inflationary trends show signs of being sustained, therefore, Walmart could suffer.
• In a worst-case scenario, Walmart can be faced with a sustained period of growing inflation, with financial losses mounting, which can lead to a quick deterioration of its healthy debt situation.

Colin Temple/iStock Editorial via Getty Images

Investment thesis: There are growing signs that we are faced with a worldwide surge in inflationary pressures. Clothing prices may rise because of the high cost of cotton we are seeing. Food prices are rising for a number of reasons, but in large part, because there are processing and in some cases transport issues. Energy price inflation has been the top headline-grabber lately. Energy price inflation tends to work its way through the entire global supply chain, given that it takes energy to produce most goods & services. Walmart (NYSE:WMT) is perhaps one of the least-adapted retailers when it comes to resiliency in the face of high, sustained inflationary pressures throughout the economy. It has been decades since its business model was tested in this regard. Aside from some short bursts of inflation, as was the case just before the 2008 crisis, Walmart mostly thrived during decades of deflationary pressures that stemmed from the globalization of the supply chain. With its profit margins already very thin, it is hard to envision how it will be able to continue to operate profitably, given that its customer base tends to be more price-sensitive compared with its peers.

Walmart's business model is built on selling high volumes at low-profit margins, catering to lower-income demographics.

The last decade or so has not been easy for most retailers. Profit margins have been getting thinner and Walmart has been no exception in this regard.

Source: Walmart Investor Relations

Walmart managed to stabilize its profitability margins in the 4% range for the past few years, after seeing years of steady decline as the chart above shows. With the cost of merchandise set to rise given the energy inflation we are seeing throughout the global economy, as well as other disruptions to the global supply chain, Walmart could potentially see its profit margins erode dramatically in coming quarters and it may not be as transitory as many people still expect it to be.

The reason why Walmart may be more exposed to the dangers of profit erosion than many other retailers is that large segments of its customer base are what can be considered to be a price-sensitive demographic.

Source: Business Insider

As we can see, the low-cost business model of Walmart tends to draw in a larger share of lower-income customers compared with its main competitors. Walmart leads in sales for all income groups under $75,000, while it trails its competitors in the $100,000 + income demographic. Within the lower-income demographic, we can expect to see a greater degree of resistance to accepting higher grocery prices as well as higher prices for other goods. This is the demographic that is set to incur the most significant hit from higher gasoline and utility bills as a proportion of their incomes. It is also the demographic that has the lowest ratio of disposable income as well as the least amount of cash reserves. Walmart will therefore have the hardest time of all major retailers in being able to pass on costs to their consumer base. It will have to choose between raising prices to keep up with the rising costs of merchandise, which will lead to a dramatic decline in the sale of certain items or accept a major cut in its profit margins, which are already very thin.

Global supply chain disruptions as well as rising energy and some base material prices are set to significantly increase merchandise costs. Within the context of developing shortages, accommodative Central Bank policies do pose a real threat to global financial stability.

News of rising energy costs becoming a significant issue first came out of Europe, where a significant and sustained decline in wind power generation just as the economy is recovering from the COVID crisis led to a chain reaction that caused not only electricity prices but also natural gas prices to spike. As it turns out there is also a growing gap in the energy supply/demand situation in Asia, where China has been experiencing shutdowns in factory activities in some regions due to a shortfall in electricity supplies. It goes without saying that China in particular and Asia, in general, are far more important for Walmart than any issues related to energy in Europe. By some estimates, as much as 80% of Walmart's merchandise comes from China, not by volume but by items offered, with other Asian countries also contributing a significant percentage of Walmart's overall merchandise supplies.

News of factory production disruptions in China is by no means good news for Walmart. It means that it does have to potentially deal with factories passing on higher energy and other input costs, while it will also have to compete with its peers for increasingly scarce merchandise, leading to an increase in overall merchandise costs Furthermore, with oil prices on the rise, transport costs are set to also rise. In terms of operational costs, higher energy prices in the US and elsewhere will lead to higher utility costs for its stores.

On the other side of the equation, Walmart can partially cope by reducing certain operating costs. It can cut administrative expenses, it can cut energy consumption by further reducing heating and air conditioning at its stores. It cannot cut employee compensation, but it could reduce the number of employees working on the store floor. It would reduce the quality of customer service, but within the context of most consumers feeling increasingly squeezed by price increases that may outstrip nominal income growth for most people, they may care more about getting a comparative bargain than they will about customer service issues. Even with these measures in place, it will be very hard to avoid significant price increases on the shelf, or alternatively accept a significant cut in profit margins.

Earned income growth has been increasing at a healthy pace lately, mostly because companies are having a hard time convincing people to return to their former jobs, without higher pay incentives.

Source: Federal Reserve Bank of St. Louis

Average hourly earnings are up 6% YTD. Inflation on the other hand has been running at a yearly rate of 5.3% so far this year.

Source: US inflation calculator

So far this year, average wage growth has been outstripping the average rate of inflation. It is unlikely to be the case going forward, given the global inflationary pressures we are seeing. It may take a few months before it happens, but I do believe that we are likely to see a shift where wage growth will lag official inflation growth. Unofficial, real inflation rates may already be outpacing nominal wage growth.

Walmart has the financial stamina to withstand a short-term decline in profitability, but a longer-term downturn if inflation will persist can lead to a significant deterioration in its financial health.

The working hypothesis in regards to inflation at the moment is that it is a transitory trend, with post-COVID normalization expected to also lead to a normalization of inflation, perhaps back to a more deflationary trend we saw last decade. If this were indeed the case, then Walmart investors would have nothing to worry about, because any weakness in its financial results might last a few quarters at most. There are plenty of reasons to expect continued inflationary pressures to persist, contrary to many expectations. Higher energy prices could persist, as I pointed out in a recent article. Other factors, such as geopolitical frictions that are causing trade frictions are also likely to continue, which will further disrupt the global supply chain, leading to supply deficits for many goods. Finally, there is very little chance of central banks intervening to fight inflation in any meaningful way, contrary to expectations. We are stuck in a global debt trap, where debt levels are just too high for central banks to be able to afford to raise rates. What this means is that the perfect inflationary scenario of ample fiat supplies and some scarcity-producing trends are converging and the trend looks to be sustained for years to come.

Walmart could easily withstand a temporary spike in merchandise inflation. It currently has a solid financial position, with debt firmly under control, with the FY 2021 levels at $44.3 billion, which is almost unchanged compared with 2014, which is the year I chose as the starting point for the profitability chart I provided at the beginning of the article. Long-term debt is currently less than 10% of yearly revenues. With interest rates remaining low for the foreseeable future, it will not be too hard to service the debt. The prospect of a severe worsening of its profitability outlook in the coming quarters and years can easily lead to a significant deterioration in Walmart's financial health in the coming years. Given that it is starting off from such a healthy situation, at first, it will not seem like something that should worry investors. A few years down the road, however, things will probably look very different.

There is of course always a chance that the high inflation scenario will not come to fruition. Maybe global energy demand will moderate, while supplies will surprise to the up-side. Perhaps trade frictions will dissipate, with all sides concluding that cooperation is better than aggressive competition. The COVID-related disruptions could become a thing of the past as well, one way or another, whether through containment of the outbreaks or through an acceptance of the fact that we may have to just live with it. Central banks around the world might also consider making fiat money less available. At this point, there is no evidence that any of these factors are headed in a more favorable direction, where they will pose less of an inflationary threat to the economy. If anything some of the above-mentioned factors such as energy costs may get worse, so there are valid reasons to expect the inflationary trend to persist for the foreseeable future.

While the inflationary pressures facing the world will most likely be a difficult business environment for Walmart, there is one aspect of it that could help with its revenues and perhaps even with its profitability prospects. Walmart may not be very strong with the higher-earning demographics, but that will likely change as even some of the more affluent households and individuals will increasingly feel the need to save some money. The prospect of higher costs for basic necessities such as food, energy, as well as higher costs for many non-essential goods & services may not have as great of an impact on households with over $100,000 or more in income, but the effects will be felt nevertheless. It is reasonable to expect therefore for more higher-income shoppers to start looking for better prices by visiting low-cost merchants. Walmart should benefit, but I doubt it will be enough to change its current dynamics that are unfavorable within an inflationary environment. It, therefore, looks increasingly like it will be tough times for Walmart and investors holding its stock in their portfolio.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.