Is Walmart Still a Profitable Giant?

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Oct 27, 2014
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Every dollar invested in Walmart (WMT, Financial) on January 13, 1978, would have been multiplied by nearly 976 times today. Walmart is one of the most succesful business stories in America, and that’s exactly what makes it the perfect study case.

What drove Walmart during its early years that made them crush competitors?

A lot has been said about this topic, creating a living myth. Recently, I came across Competition Demystified by Bruce Greenwald, and among the several business cases that the book develops, I believe Walmart to be one of the most fascinating.

Here are the 5 most common explanations of WMT’s outlier success. To determine if they are valid, we will need not only first-level thinking but to dig deeper and use second-level thinking as Howard Marks (Trades, Portfolio) says. Let’s use a 0-5 scale to determine their explanatory rating and power.

  • Explanation 1: Beat up on the vendors
  • Explanation 2: Small-town monopolist
  • Explanation 3: Better systems and management
  • Explanation 4: Cheaper things in the South
  • Explanation 5: Potent advantages of regional dominance

Explanation 1: Walmart has a reputation for squeezing suppliers to provide the lowest possible prices, which translates into higher profit margins. Taking an historical look we can observe that WMT’s COGS is higher than that of its competitors. Another interesting observation is that its gross profit margins did not increase as WMT expanded.

However, there were two fronts in which WMT was better than the competition: inbound logistics (since distribution centers were at the most 300 miles to the stores) and shrinkage levels, or the amount that was lost, damaged or stolen from inventory.

During its early years, WMT had nearly the same muscle to use in negotiations that other retailers, such as Kmart had. There is indeed a risk in being inflexible in negotiations since not carrying the big brands could harm sales and relations with other suppliers.

Explanation’s rating: 0

Explanation 2: Since the beginning of its operations, Walmart has prided itself on its low prices. Evidence from 1984 found that the company indeed incurred in price discrimination across the country, charging lower prices where competition was tough, and higher prices in small towns.

In 1984, Kmart and other discounters had around 12% of their stores in single-store towns, while Walmart had 33%. However, on balance, the one-store-town advantages were offset by the “everyday low price policy.”

Explanation’s rating: 2

Explanation 3: Walmart’s management was one of the pioneers in terms of using technology such as bar-code scanners to manage their inventories and sales data. The heavy investment of nearly half a million dollars per store did not stop the company in its implementation. Could this have represented a competitive advantage?

Scanning was an industrywide technology coming from a third-party, such as IBM; it is hard to say that this was unavailable evenly among competitors.

What really set WMT’s management apart was its involvement with and commitment to the company. They had regular meetings every Friday and Saturday in which managers from all around the country gathered to discuss strategies and ways to become better. (Remember they were not as dispersed as today).

The motivation and culture that Walton promoted was very succesful in attracting and retaining talent on all WMT’s lines. Measures such as offering stock at discounts were effective in sharing ownership and responsibility. Managers were very active in supervision and idea sharing, translating into cost savings and lower shrinkage, as discussed earlier. This indeed helped operating margins and reduced SG&A.

Explanation’s rating: 3

Explanation 4: Walmart had lower rental (0.3% of sales) and payroll expenses (by 1.1% of sales) than the industry averages. Since rental expenses were lower in the South, and employees were not represented by a Union (following the South’s tradition), we could infer that this explanation is correct.

However, to determine the exact amount that propelled WMT’s competitive advantage is difficult, given that Southern locations were also limited and eventually WMT expanded into more expensive locations.

Indeed, the company enjoyed lower costs in the South, brought together with the ability to charge higher prices since they had little competition. During the expansion and golden era, these two certainly helped in achieving higher margins and returns than competitors. However, as the stores' dispersal started, the metrics started reverting to good, but not remarkable, levels.

Explanation’s rating: 2

Explanation 5: Walmart enjoyed a competitive advantage based on the combination of economies of scale with some limited customer commitment. Both the economies and the commitment are regional, not national or global. For retailing, distribution and other industries in which most of the costs of reaching the final consumers are at the local and regional levels, these are the economies and preferences that matter.

Walmart played small, smart and local before going after world dominance. With this, even at a relatively small size, it beat big retailers in profitability.

Explanation’s rating: 3

So what’s the conclusion?

Let’s examine what really influenced WMT based on our ratings: a mixture of local dominance, good management (especially supervision), and access to cheaper resources in the South (only at the beginning).

These gave the company an operating margin advantage of 4-5% of net sales over its competitors in the golden years.

Walmart kept growing after 1985 until it became the world’s largest retailer. However, its profitablity shrank considerably. The explanation: as it expanded across the country and overseas, it was unable to replicate its local economies of scale with enough customer loyalty. This would have meant difficulties for competitors to cut into its base. As it grew, WMT had to compete on a level playing field.

Greenwald states that perhaps the correct strategy would have been to pursue the same local dominance with customer-commitment model in another country, such as Brazil in the '80s or South Korea. Instead, the company decided to “grow at a price,” which meant lower returns as it expanded into the U.S. and the rest of the world.

Walmart is now competing in several markets with different underlying economies and environments. I still believe WMT will keep on posting acceptable returns, however, nowhere near the numbers we saw decades ago as growth has made the company less efficient and dominant.

For retailers, the crucial competitive advantage lies in local economies of scale. Walmart has taught us that even the most glorious companies reach a point in which they have to choose between size and profitability, with nearly all of them choosing growth.

What do you think?