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Walmart Stores (WMT)

On August 16, 2018, Walmart's stock rallied 10% following its second-quarter 2018 earnings beat. We reviewed the company's latest update and what it means for Walmart's appeal as a dividend growth investment here.

Founded in 1945 in Bentonville, Arkansas, Walmart (WMT) is the world’s largest retailer and operates on a truly staggering scale. For example, its 2.3 million employees serve 260 million consumers per week in 28 nations via more than 11,700 stores that collectively sell close to $500 billion in goods annually. 

A little over half (53%) of Walmart’s stores are located in international markets, which the company entered in 1991. These serve about 100 million customers per week under 55 different banners (store brands).

While Latin America, Brazil, and Mexico are important regions, the majority of Walmart’s sales and profits are derived from the company’s U.S. stores (64% of revenue in fiscal year 2017) and Sam’s Club (12%).

Walmart sells just about everything in its stores. Grocery (56% of U.S. sales) is Walmart’s biggest merchandise category, followed by health & wellness (11%) and general merchandise (33%). Walmart has its own private-label store brands, but branded merchandise still represents a significant portion of total sales. The company’s general strategy is to be the low-price leader in its categories.

In addition to its significant brick-and-mortar operations, Walmart has fast-growing e-commerce websites operating in 11 countries. Walmart.com averages more than 80 million unique visitors a month and offers millions of products that can be shipped or picked up at one of Walmart’s many physical locations.

E-commerce sales account for less than 5% of the company’s total revenue today but will continue growing in importance as Walmart invests less in new store openings and more in its digital operations, supply chain, and logistics.

Business Analysis

Walmart's claim to fame is twofold. First, the company prides itself on its "everyday low price" (ELP) strategy, which has been its guiding mantra since its founding. 

This intense focus on low cost is made possible by Walmart's biggest competitive advantages, which are predominantly its dominant size, economies of scale, and the nation's largest distribution and logistics network. 

The company has spent over 50 years and tens of billions of dollars building, adapting, and perfecting its massive store network. In a highly competitive, low-margin industry like retail, few rivals have the financial resources or patience to try to replicate the company's dominant supply chain. 

For example, Walmart's 5,400+ stores in the U.S. are located within 10 miles of 90% of the population. These locations are served by a logistics network that:

  • Sources products from more than 100 countries (to get the lowest cost) 
  • Has over 150 distribution centers (which average over 1 million square feet and employ over 600 people each)
  • Runs a fleet of more than 6,100 trucks, 61,000 trailers, and 7,800 drivers (who average 100,000 miles per year each)
  • Has each center support 90 to 100 stores within a 150 mile radius
  • Has each distribution center send out around 200 trailers per day of products

Another key factor to Walmart's success (and why it's been able to become a dividend aristocrat with 44 consecutive years of payout increases) is the company's adaptability.

For example, in 1987 Walmart concluded that it had largely saturated the U.S. market with its traditional discount centers (which average more than 100,000 square feet). As a result, the company decided to break into the U.S. grocery market via the launch of Walmart hypermarts.

The success of hypermarts (they generated about five times the weekly sales volumes of traditional Walmart discount stores) caused Walmart to roll out its modern Supercenter stores (averaging 186,000 square feet). These in turn transformed Walmart into America's largest grocer with nearly double the market share of its nearest competitor, Kroger (KR).

Supercenter stores with a strong focus on grocery items, which draws predictable traffic, also increased Walmart's product turnover, resulting in better sales per square foot than rivals like Target (TGT). 

  • Costco (COST): $1,100 per square foot
  • Walmart: $420 per square foot
  • Target: $290 per square foot

Costco's much larger sales per square foot are the result of its wholesale warehouse business model, in which customers pay a membership fee and generally buy massive quantities of very low-cost goods.

Walmart has also copied the Costco model with the 1983 founding of Sam's Club, which now has over 800 stores across the world and generates 12% of the companies sales.

Further evidence of Walmart's adaptability can be seen in the company's launches of international stores (starting in 1991), as well as its 1998 concept, the Neighborhood Market, which is a much smaller store (averages under 40,000 square feet) designed to miniaturize a supercenter but for urban markets.

The Neighborhood Market concept is appealing because urban areas have traditionally been impractical for giant big box stores due to their density, high real estate prices, and zoning regulations.

Of course, what many investors have been worried about in recent years is the threat that e-commerce, especially Amazon (AMZN), might pose to the company. That's understandable as Walmart suffered through several years (starting around 2014) of declining same-store sales, falling revenue, and shrinking earnings.

However, management has done a good job of adapting the company's business model yet again, with a strong focus on integrating online sales into its massive existing store base.

For example, in 2016 Walmart bought Jet.com, a leading online retailer, for $3.3 billion. The deal brought with it Jet.com founder Marc Lore, who became Walmart's head of online retail. Lore instituted a flurry of secondary acquisitions and joint ventures with various e-commerce giants to quickly ramp up Walmart's competitive position in online retail.
Source: Walmart Investor Presentation

Part of that strategic focus was better integrating Walmart's biggest strength, its nationwide distribution and logistics supply chain, to work smoothly with the patchwork of new online businesses and brands. This includes an attempt to copy Amazon's "one-stop online shopping" experience and maximize consumer convenience at all levels.

                               Walmart Online Convenience Initiatives
Source: Walmart Investor Presentation

Today Walmart offers free two-day shipping to 99% of U.S. residents and can ship next day to approximately 87% of the population.

The results of Walmart's online efforts have been impressive with the company expecting 40% growth in 2018. Analysts expect Walmart's online sales to grow 30% a year through 2022, when they are expected to make up about 10% of total company sales ($57 billion out of about $570 billion).

As impressively, Walmart has managed to turnaround its struggling U.S. stores and has now enjoyed 13 consecutive quarters of positive same-store sales growth. In fact, Walmart's growth has even accelerated due to the success of its e-commerce integration. In recent quarters, Walmart has reported that about 30% of its same-store sales growth was being fueled by e-commerce.

The rest of the growth is due to several factors, including the company's recent big push into upgrading/remodeling many of its stores (better lighting, wider aisles, and lower shelves) and increasing worker wages and training to lower turnover (training new employees is expensive and inefficient).

Overall, Walmart has simply become a much more focused company. Management's improved capital allocation discipline and response to changing consumer shopping habits is demonstrated by the company opening fewer new stores and maximizing the sales from its existing store base, including with ever-larger e-commerce integration.
Source: Walmart Investor Presentation
Going forward, store openings are going to be a much smaller focus for the company, with most new stores being planted in international markets such as China and Mexico. Far more of Walmart's future growth is likely to come from ongoing store refurbishments (driving stronger comps) and e-commerce.
Source: Walmart Investor Presentation

The company expects its more disciplined approach to capital spending will generate over $20 billion a year in free cash flow going forward, continuing to fuel generous returns of capital to shareholders via dividends and buybacks. 

While there is still plenty of work to be done, Walmart appears to be making solid traction on its plans to prove that it can, once again, successfully adapt to a fast-changing retail world and compete on a massive scale. 

However, while Walmart has managed an impressive growth turnaround, there remain several risks to its continued success.

Key Risks

Consumer retail has always been, and will continue to be, a cutthroat industry marked by a relatively little customer loyalty. In other words, it's generally a massively competitive world characterized by a race to the bottom on price.

This is especially true given that Amazon's founder, Jeff Bezos, has a "your margin is our opportunity" approach to business. In other words, Amazon's primary goal isn't necessarily to maximize profits today but to gain market share by offering a greater number of products and services delivered in an ever-more convenient and affordable manner.

So while Walmart's online sales are booming, there is no guarantee that it will be able to enjoy even the slim margins it has in the past. In fact, in the last two years Walmart's operating margins have shrunk from 5.1% to 3.9%, indicating that its solid growth in online sales isn't necessarily translating to its bottom line.

Now it is true that Walmart has historically been one of the best retailers in the world at cutting costs via its efficient supply chain. The good news is that future innovations such as automation and robotics (self-driving trucks) are also expected to help cut supply chain costs by about 30% in the coming years, according to analyst firm McKinsey.

However, that doesn't necessarily mean that Walmart's margins will find relief. Because in the highly competitive retail world, over time most cost savings end up being passed on to consumers.

Another challenge for Walmart's profitability is its impressive turnaround in physical stores. Specifically, the company's greater focus on a higher paid but better trained and happier workforce won't come cheap.

Walmart has been raising wages for several years now and just lifted its minimum starting wage to $11 per hour. Its average U.S. worker now makes $13.85 per hour. However, rival Target has said that by 2020 it will be paying a minimum starting wage of $15 per hour in a similar effort to create a higher trained, happier workforce that results in lower turnover.

Market competition could force Walmart's labor costs to keep rising for several more years, further squeezing its struggling profit margins.

Finally, much of Walmart's growth potential lies overseas, especially in markets such as China, where it's opening a large number of new stores. These regions have very different consumer cultures, and the company doesn't have the dominant logistics and distribution infrastructure it enjoys in the U.S.

In other words, Walmart has fewer advantages when it enters a new market in foreign countries. Instead, it's competing with well-established local giants who have spent decades creating and optimizing their own product mixes and distribution networks.

As a result, Walmart's overseas stores have lower margins and can experience much greater volatility in customer traffic and same-store sales. While trying to recreate its U.S. success around the globe sounds appealing, this expansion strategy is far from guaranteed to be a profitable success story, especially in China where Walmart must contest with Alibaba (BABA), the Amazon of China.

Alibaba's founder and CEO, Jack Ma, has even larger growth ambitions than Jeff Bezos. In fact, Ma has stated that he hopes to turn his company into the 5th largest economy in the world by 2036, supporting 100 million jobs through 10 million businesses on its increasingly global platform. That platform includes everything from online sales, to e-payments, to cloud-based enterprise services.

In other words, whether Walmart tries to grow domestically or abroad, the company faces intense competition from very well-capitalized rivals, many of whom have proven far more nimble than it at disrupting the world of retail.

Closing Thoughts on Walmart

While the retail world has always been highly competitive, Walmart has done an admirable job adapting to changing industry conditions over the years. That includes an impressive entrance into e-commerce that should help the world's largest retailer remain relevant in the coming years. 

Similarly, the company's high mix of defensive grocery products and dedication to rewarding dividend investors with over 40 consecutive years of payout increases make it a fairly low-risk dividend stock.

With that said, Walmart's recent success in growing its same-store sales and e-commerce operations has thus far failed to result in anywhere near the bottom line growth it has historically enjoyed. Online sales have compressed the company's margins while demanding substantial capital investments, and their long-term profitability remains uncertain. 

Walmart is an interesting dividend aristocrat to watch because of its scale and defensive qualities, but the many challenges the company faces going forward shouldn't be ignored either. For now, Walmart seems likely to remain a low-growth cash cow that should only be considered when its yield is relatively high.

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