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Stock Downgrades: Chinks in Wal-Mart’s Armor

A Goldman Sachs analyst downgraded shares of Wal-Mart, citing its expansion plans and soft same-store sales, but some said he is off base.

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This story first appeared in the December 9, 2004 issue of WWD.  Subscribe Today.

NEW YORK — Is Wal-Mart Stores Inc. getting so big — at least in the U.S. — that its expansion is at the expense of sales growth? At least one analyst thinks so, and another sees continued lackluster sales at the world’s biggest retailer.

Goldman Sachs equity analyst George Strachan downgraded shares of the company Wednesday, citing the potential negative impact of Wal-Mart’s expansion plans on the company’s waning same-store sales momentum.

An analyst with First Global also dropped the rating on Wal-Mart’s stock to “market perform” from “moderate outperform.”

But several other analysts say it’s too early to tell if Wal-Mart stores would experience a “cannibalization of sales” as it continues to grow its store base in the U.S. Rather, they say, Wal-Mart’s strategy may maintain sales and customer loyalty. Further, the company’s strategy is a successful way to beef up its market share, especially in the grocery store business.

“Because Wal-Mart plans to open 950 Supercenters over the next three to four years, self-cannibalization, or ‘market development’ as the company calls it, could remain a challenging phenomenon, particularly trying in a period when comp-store sales are growing below historic trends,” Strachan wrote in a Wednesday report to clients in which he downgraded shares of the company to “in line” from “outperform.”

Wall Street shrugged off the news, sending shares of the company up 0.02 percent to close at $52.51. Wal-Mart spokesman Gus Whitcomb said the company does not comment on analyst reports or movements.

Strachan said the “self-cannabilization” could be why general merchandise sales have been soft at the retailer of late. Wrote Strachan: “We have been surprised…at how much self-cannabilization Wal-Mart was willing to inflict upon itself. The company deliberately plans to cannabilize its stores when they reach volumes of $100 million or more a year,” which can result in same-store sales declines.

While not yet seeing declines in comps, Wal-Mart reported in early December consolidated November same-store sales that rose 0.7 percent, below both the company’s and analysts’ estimates for a 2 to 4 percent gain. The latest results continued the company’s trend in the past year of sales below historic levels. The company foresees December comps in the ever-important holiday quarter up just 1 to 3 percent.

Strachan said Wal-Mart’s general merchandise same-store sales at discount stores and Supercenters year-to-date are up between 0.5 percent to 1.5 percent, versus total divisional comp gains of 3.4 percent year-to-date. Rival Target Corp., in comparison, has seen a 4.9 percent increase in comps year-to-date.

Wal-Mart management consistently cites higher gas prices as hurting its generally lower-income consumer’s discretionary spending budgets. But Strachan isn’t so sure that’s the whole story, citing what he sees as the self-cannabilization partially responsible for the weaker comps.

Strachan said Wal-Mart indicated at an October analyst meeting that while it plans to open Supercenters as close together as possible, the company said that “self-cannibalization is a necessary by-product of this strategy.” He added that the company “even expressed willingness [on a short-term basis] to trade return on investment for ultimate market saturation.”

At an investor conference in 2003, Lee Scott, Wal-Mart’s president, chief executive officer and director,  said the company was “finding [that] we can put more Supercenters closer together than we ever dreamed of in our life.” At the time, Wal-Mart was testing Supercenters five miles apart.

Speaking at a Prudential Equity Group conference in September, Scott again seemed to see no obstacle to Supercenter growth, calling the format “incredibly, incredibly strong. It is not unusual to open these things at $100 million, $110 million, $120 million the first year.”

The company’s five-year plan, he emphasized, calls for “adding Supercenter after Supercenter after Supercenter and maximizing shareholder value that is created by that vehicle….Our plan is to open more every year during the next five years.”

The company has three years’ worth of approved store locations already in the pipeline, chief financial officer Tom Schoewe said at the analyst meeting in October. Wal-Mart plans to open or relocate 240 to 250 Supercenters in 2005.

Schoewe discussed an internal study of 500 stores that saw sales declines when a new store opened nearby. Within two years, stores that had been hurt recovered to the point that overall market share increased, according to a research report written by Smith Barney analyst Deborah Weinswig, who attended the meeting.

In one specific example from the study, a store saw sales drop 13 percent initially when a new store was built four miles away. However, by the end of the 24-month tracking period, the two stores were taking in a combined $239.6 million, up from $131.4 million recorded by the single store alone.

It’s important to note that Wal-Mart had initially envisioned using its neighborhood market format to fill in the gaps between stores. But that plan was scrapped.

Meanwhile, several analysts downplayed the Goldman Sachs downgrade.

Richard Hastings, retail analyst at Bernard Sands LLC, said market share is in fact “going to be the story here.” He disagreed with Strachan’s overall reasoning, saying that cannabilization isn’t  a worry, and that it’s likely not what is causing the retailer’s weak comps.

Hastings said Wal-Mart stores located near each other “is a normal cyclical development. The company is maturing. It’s not a double-digit growth story in the U.S. anymore….They’re going to try to block out the competition.”

“Wal-Mart has always taken a very aggressive stand that they’d rather take business away from themselves than have someone else do it,” observed Neil Stern, retail analyst with McMillan Doolittle. “They watch and measure cannibalization very closely. Texas, and Dallas in particular, are areas where they’ve opted to experiment with how close they can open stores.”

Stern suggested Goldman’s downgrade had more to do with stock performance, and reports of a potentially weak holiday performance, than any fundamental problem in Wal-Mart’s strategy.

“Analysts hate it, but the reality for Wal-Mart, Home Depot and other mature companies is that cannibalization is going to be somewhat necessary to grow overall market share,” he said. “That’s the goal, and you may have to sacrifice comps to get it.”

One hedge fund manager who requested anonymity said the idea of having several stores in one market makes sense. “The lines in [Wal-Mart’s existing] stores are long, they’re too crowed….To me, it’s amazing to look at today, Dec. 8, and say this is the inflection point where now all of the sudden cannibalization is going to hurt them.”

Joe Beaulieu, an analyst at Morningstar, agreed. “If you have a store that’s running at say 125 percent of capacity, numbers are going to look good until people get sick of always waiting in line or not getting a parking spot.” By opening a new store nearby, it would likely alleviate the “crowdedness” and make shopping a more pleasant experience, thereby preserving customer loyalty.

Generally, however, Wal-Mart hasn’t been opening stores in existing markets long enough for the true impact on the other stores to have already been felt, said another analyst.

“Is one season enough to start throwing judgment? I don’t think it is,” said Ulysses Yannas of Buckman Buckman & Reid.

Yet, the case can be made for why having multiple locations in one market is good. Besides improving the shopping experience because consumers are faced with less crowding, having more stores in a certain square mile radius improves expense control. Distribution and advertising become easier and less costly, Yannas said.

Wal-Mart can also improve management of product momentum in certain categories and have better knowledge of demographics in certain markets, Hastings added.

Bob Nardelli, ceo of Home Depot, had the idea “to un-clot the stores, so it initially hurts the comps, but eventually it helps in terms of people being able to shop easier,” said Yannas.

“You can find clear evidence of a maturation of market share [in Home Depot’s strategy],” said Hastings. “What it leads to is a slower rate of top-line growth with an improvement in the future of smoother earnings.”

Analysts also agree that higher energy prices and the uncertain employment picture is impacting Wal-Mart’s target customer’s ability to spend, both of which Wal-Mart itself has cited over the past year.

In addition, competition from the dollar stores, such as Dollar General and Family Dollar, are likely taking sales away from Wal-Mart, the fund manager said.

Beaulieu said “self-cannabilization” at Wal-Mart is far down on his list of concerns for not buying stock in the world’s largest retailer.  “There are plenty of reasons not to like the [Wal-Mart] stock. Is this the worst one? I think not.”

According to its Web site, Wal-Mart plans to open 50 to 55 discount stores in fiscal year 2005, as well as 220 to 230 Supercenters. Twenty-five to 30 new Neighborhood markets will also be opened, while internationally, 130 to 140 new units will be opened in fiscal 2005. In all, planned square footage growth will represent an increase of 8 percent over fiscal 2004.

Due in part to the large amount of stores the company is opening, “You’re not going to see double-digit comps ever come back again,” Hastings predicted.

“But that’s not important because now they’re gaining market share,” he said. “The grocery store is gaining market share all over the place…that’s part of the strategy.”

Schoewe’s comment on a fiscal 2003 year-end conference call summarizes Wal-Mart’s stance.

Speaking about the performance of stores opened in fiscal 2003, he noted “rather than being concerned about cannibalization or saturation, the key take-away is $17 billion [in additional sales volume], which is great news.” He predicted 100-plus basis points of cannibalization for fiscal 2004.

Stores with annual volumes of $100 million or more are candidates to have a sister store open nearby. In 2003, 290 Supercenters generated sales of over $100 million or more. Wal-Mart has most of its stores in the southern U.S.; it still has significant U.S. expansion room since it has barely tapped into California, itself the largest domestic market.

In addition, Wal-Mart has only a handful of total stores in major Northeast metropolitan areas such as New York, Chicago, Philadelphia and Boston, and virtually no Supercenters there.

As it chooses how and where to grow, Wal-Mart will have to balance the needs of its food business — which can generally work off smaller trade areas — with its more profitable general merchandise business, where cannibalization is more of an issue.

George Whalin, president of Retail Management Consultants, said Wal-Mart should have plenty of room to grow in the U.S., provided it cleans up its image problems.

“I know they are paying a lot more attention to their image and have made some pretty smart moves there,” he said. “It’s important to clean that up here, because international growth is much harder.”

Wal-Mart’s Decelerating Sales Growth

1999 to 2000 15.9%
2000 to 2001 13.7%
2001 to 2002 12.2%
2002 to 2003 4.9%

Wal-Mart at a Glance

Wal-Mart Stores: 1,363
Wal-Mart Supercenters: 1,672
Sam’s Clubs: 550
Wal-Mart Neighborhood Markets: 76
Wal-Mart International: 1,572
Distribution Centers: 110
Customers Served Each Week: 138 million
Markets: In all 50 states. International locations: Puerto Rico, Canada, China, Mexico, Brazil, Germany, United Kingdom, Argentina and South Korea.

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