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Wal-Mart's pricey gamble
The giant retailer hopes to solve its growth problems by targeting a new type of shopper. But investors should know: it's facing a dangerous year ahead.
By Jim Jubak
Wal-Mart is betting the store on a new strategy.
If it works, the strategy will re-ignite growth at the mega-retailer and revolutionize retailing -- again. If it doesn't, doubts on Wall Street about Wal-Mart Stores' (WMT, news, msgs) future growth are likely to get worse. The company runs the danger of destroying the competitive advantage that fueled 15%-a-year earnings growth over the last 10 years.
What are the odds that Wal-Mart will win its bet? No better than 50/50. Wal-Mart is proposing nothing short of completely re-inventing itself, and that's never easy. For every General Electric (GE, news, msgs) that's pulled off the job successfully, there are a half-dozen like Hewlett-Packard (HPQ, news, msgs) that botched it.
Most retailers would kill to have Wal-Mart's problem. Sales growth was 11.3% in 2004 and, before Hurricane Katrina slammed into the U.S. economy, researcher Value Line was projecting 2005 sales growth at 10.3%.
Which is none too shabby, unless you're Wal-Mart. Wall Street remembers the heady days of 1998 to 2000, when the company averaged annual sales growth of 17.5%. That's 70% better than this year's projected sales jump.
An everyday low stock price
The slower growth has created a huge problem for the stock: Investors have been steadily cutting the price-to-earnings ratio they're willing to pay for Wal-Mart's earnings because the company hasn't convinced investors it has a fix for slowing sales growth. After climbing from 21 in January 1998 to 44 in January 2000, the stock's P/E ratio has been in a steady decline, even as the stock market as a whole has recovered from the bursting of the bubble of 2000. Today, Wal-Mart's shares trade at a P/E of just 17.3, even though earnings per share are projected to grow by 14% a year over the next five years.
Compare that to PepsiCo (PEP, news, msgs), which trades at a P/E of 24.5 with earnings projected to grow by just 11.1% a year over the next five years.
Related news and commentary on MSN Money
By giving Wal-Mart's higher projected earnings growth a lower price-to-earnings multiple, the stock market is signaling that it doesn't have a whole lot of confidence in those projections. If the projected growth isn't likely to show up, then who wants to pay for it?
It's that skepticism that has led the stock to post a 17.2% loss in 2005, as of Oct. 5. For the five years that ended on Oct. 5, Wal-Mart's shares have returned precisely zero. A goose egg. Nada. Quite a turn for a stock that returned 295% for the prior five years from October 1995 to October 2000. (Although, I grant you, Wal-Mart did outperform the Dow Jones Industrial Average ($INDU, news, msgs), which lost 5% during the recent five-year period.)
Why that skepticism?
The company's recent results have earned it. For the second quarter, Wal-Mart reported its smallest quarterly earnings gain in four years, and the U.S. division missed its sales target for the second straight quarter.
But the skepticism has deeper roots than just a couple of quarterly earnings misses.
In the near term, Wal-Mart says higher oil prices mean less buying by lower income customers. Those customers, who have less discretionary income to start with, disproportionately cut their spending when prices climb at the gas pump. The company estimates that higher oil prices since the start of 2005 have cut same-store sales growth from a projected 5% to a 2%-to-4% range.
Target-ing a new customer
Unfortunately for Wal-Mart, that oil-price-related drop in same-store sales feeds right into a worry that dogged the stock even before oil prices soared this year. Growth in sales per store dropped from 8.7% in 2001 to 5.7% in 2002 to 0% in 2003, and then rebounded to 3.2% in 2004. Almost all of Wal-Mart's sales growth was a result of the company opening new stores. Store count climbed to 5,289 in 2004 from 4,906 the year before.
And disappointing same-store sales growth wouldn't be such a problem if the company's costs hadn't crept up. Wal-Mart is unmatched when it comes to squeezing the last penny out of a supplier's price, and the company has become even more aggressive in the last two years about scouring the globe to find the cheapest supplier. Nonetheless, costs in a category called Sales, General and Administrative have been climbing as a percentage of sales revenue to 17.9% in fiscal 2004 from 16.3% in fiscal 1999. Three reasons: rising costs per employee, higher advertising spending (up 45% in 2004) and spending to improve the "fashionability" of its stores and the clothes that Wal-Mart sells.
As a solution to its woes, Wal-Mart has come up with a radical change of direction. This strategy attempts to adopt some of Target's (TGT, news, msgs) successful marketing strategies for attracting higher-income shoppers, although I'm sure Wal-Mart management will hate that description. Wal-Mart will upgrade its stores so that they feel less like warehouses, actually display merchandise in wider aisles rather than simply stacking it, and add more high-end merchandise to the mix.
Wal-Mart Chief Financial Officer Tom Schoewe told investors at a Bank of America conference that it was now selling an 8-megapixel Canon digital camera for nearly $1,000. The company is opening a fashion observation post in New York's Garment District in order to stay on top of current trends. (This effort has already paid off: on Oct. 4, the Anthropologie unit of Urban Outfitters (URBN, news, msgs) sued Wal-Mart, charging that the company had copied some of the company's clothing and fabric designs.) Wal-Mart is also increasing the store presence of its own in-house fashion brand George. There are rumors that Wal-Mart has been talking to Tommy Hilfiger (TOM, news, msgs) about an acquisition. And Wal-Mart certainly raised fashion-industry sunglasses when it took out an eight-page spread in the September issue of Vogue. Vogue!
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