By and  on February 17, 2005

NEW YORK — Brace yourselves Macy’s, Lord & Taylor and J.C. Penney: Wal-Mart could be headed to a mall near you.

Opposition to the growth of Wal-Mart Stores Inc., which today is expected to post a 15 percent earnings per share gain on an 11 percent sales increase for 2004, might be missing the mark.

In New Jersey, for example, the state legislature is examining a bill to halt the construction of all diversified big-box retailers within the state except for category killers such as Home Depot and Best Buy. In sales-tax-free Montana, lawmakers have proposed a bill dubbed the “Wal-Mart tax,” which would impose gross-receipts tax on the state’s largest retailers for their consumption of natural and labor resources. And in New York City, politicians are building careers — and grabbing media face time — by battling the world’s largest retailer over a proposed store in Rego Park.

But in these attempts to slow the development of massive Wal-Mart supercenters, politicians and advocacy groups are ignoring what might really be the retailer’s key expansion play: malls.

“Our preference is to be one-level and stand-alone because it’s much more cost-effective and easier to operate,” said Peter Kanelos, a Wal-Mart regional director of community affairs in California. “But if we can’t develop for lack of available land, then in order to meet the needs of consumers, we figure out how to adapt our stores.”

This is music to the ears of mall owners, who are thirsting for growth opportunities and looking for new anchor tenants as department store chains consolidate. So they are eager for Wal-Marts and Targets to move in (Target also reports its 2004 figures today).

“We have to keep [our malls] relevant,” said Peter Lowy, managing director of Westfield Group. “We have to keep up with retailers that are expanding, and they happen to be the Wal-Marts, Costcos and Best Buys of the world. We have to adapt our malls to fit them in.”

Last October, Wal-Mart opened its first multilevel store designed specifically for a mall in the Westfield Shoppingtown Parkway in El Cajon, Calif. The retailer has a few other mall locations, sites where it took over vacant department stores, such as a two-level, former Sterns store in the Sunrise Mall in Massapequa, N.Y.But the Westfield site in El Cajon is a monster at 167,000 square feet, which is close to the size of a Wal-Mart supercenter, and well above the 98,000-square-foot format of its regular discount store. The Westfield store is the largest Wal-Mart anywhere in San Diego County and anchors the mall, along with a Robinsons-May, J.C. Penney, Mervyn’s and a Sears.

Though sharing its customers with other retailers seems antithetical to its approach, the relationship of Wal-Mart to a mall has proved mutually beneficial.

“Somebody out to buy a new outfit for prom that night may go to the mall, and while they’re there, they can stop and get film for the prom pictures,” said Wal-Mart’s Kanelos. “It’s about convenience.”

A mall-based strategy for Wal-Mart also makes business sense. According to analysts, there is plenty of retail real estate in the market, but it’s not good real estate. Expanding into key markets clustered with consumers holding higher discretionary income levels may be the type of growth strategy Wall Street applauds. Shares of Wal-Mart, although trading at valuations above most indexes, have been stalled at between $50 and $60 for the past year.

And growth is imperative for the retailer, which is more difficult the larger it becomes. Wal-Mart is experimenting with a variety of formats in the U.S., from Neighborhood Stores to city-center units to mall-based units, as it attempts to maintain its momentum. The retailer plans to open 480 stores this year across all its formats, including Sam’s Club. Several years ago, Lee Scott, Wal-Mart’s chairman and ceo, said in an interview with The Financial Times that he saw no reason why the chain could not continue to grow by 10 percent a year for the foreseeable future by adding more stores to markets where it already had several.

As a result, Wall Street will be keeping a close eye on the retailer’s merchandising initiatives and expansion plans for 2005 when Wal-Mart reports its results today. Regarding mall-based growth, the opportunities seem viable.

According to retail design firm FRCH Design Worldwide, mall stores give retailers like Wal-Mart a chance to experiment with new merchandising plays. The mall stores have smaller floors — though they are often bigger than stand-alone stores by 30 to 40 percent — allowing for shallower departments. This makes shopping in the aisles less daunting and more comfortable when walking in from the perimeter of a store, said Andrew McQuilkin, design director at FRCH.For Australian-based Westfield, which owns Shoppingtown Parkway and plans to build a Target store in its property at San Fernando Valley, the benefits of adding discounters to malls is clear. And for some of the smaller mall-based retailers, having a Wal-Mart or Target nearby is convenient and can draw traffic to their stores.

Dawn DaSilva, manager of Carbon, a retailer that offers inexpensive, independent brands, said, “It’s really positive for us. Well, it doesn’t affect our store so much because we’re all apparel, but it has been really positive for us anyways. If I need paper towels or supplies, I can just hop over there. So it’s convenient.”

Robert Villegas, manager of C28, a Christian retail chain, sees Wal-Mart’s presence at the Westfield mall as a blessing. “We are seeing more traffic flow. There’s not too much as far as sales increase, but for us it’s awesome anyway. The more traffic the better because for us, selling Christian alternative clothing, we want the opportunity to meet as many people as possible. We weren’t worried too much about competition, because we offer something that Wal-Mart never would. Except we do offer similar music. We try to be competitive but they sell at better prices a lot.”

In order to capitalize on the traffic Wal-Mart would bring to the mall in El Cajon, Lowy built additional entrances and required that all of the retailer’s check-out stations faced the interior of the mall, to encourage customers to cross-shop the mall rather than go from Wal-Mart directly back to the parking lot.

Ultimately, the addition of Wal-Mart to the property is expected to bring the center’s annual revenue to $400 million. Based on its success, Wal-Mart and Westfield are also working on adding a store to the developer’s mall in downtown Sacramento.

“European malls are based on hypermarkets,” said Lowy. “To us, this is just the natural order of things, and the U.S. market is moving toward it.”

The mall strategy makes sense given the challenges Wal-Mart faces. Both Wal-Mart and Target stand the chance of missing analysts’ estimates for their 2004 results, while full-year 2005 guidance from the two discount chains could influence investor sentiment in the day’s stock market session.Amid Wal-Mart’s own forecast for quarterly earnings of 73 to 75 cents a share, the consensus estimate of Wall Street analysts is for a profit of 74 cents. In the fourth quarter of the prior year, earnings per share were 63 cents.

A.G. Edwards & Sons Inc. analyst Robert Buchanan forecast Wal-Mart earnings at 73 cents, a penny below consensus, saying in a recent research report that while management “kept its focus” amid unionization bids and class-action lawsuits, the company’s “merchandise offering lacks verve.”

Sanford C. Bernstein & Co. LLC analyst Emme Kozloff, however, said in a Tuesday research report that she expects a profit of 74 cents from Wal-Mart and added that her estimate could be conservative given the upside the retailer’s other recent quarters have seen due in part to gross margin improvements. In the fourth quarter, for example, Kozloff sees a 35 basis point increase in gross margin and a flat year-over-year operating margin of 6.3 percent.

But Kozloff predicted that the quality of Wal-Mart’s expected fourth-quarter earnings could be low, saying that “for the second quarter in a row, nonoperating items drove over 60 percent of the earnings growth rate — 35 percent from a lower tax rate this year and the remainder from ‘other income’ and share repurchase.”

News of more international expansion from the company, particularly in China, will also be on investors’ minds. Recent reports citing the State Council Development and Research Center pegged China’s economy to grow at 8 percent over the next five years, and Wal-Mart is reportedly planning to open hundreds of stores there in that time.

Kozloff is expecting a positive tone on Wal-Mart’s recorded earnings call, even though she does not expect much more than a full-year earnings guidance from the company, up in the mid-teens on a percentage basis, which would be in line with current consensus estimates for $2.73.

Looking to Target, the company is poised to report a lower fourth-quarter profit, despite sales in the period that were clearly boosted by bargain-hunting holiday shoppers. Same-store sales in January alone spiked 9.4 percent, which followed a 5.1 percent comp advance in December. The company, however, said in a Feb. 3 press release that changes to two accounting metrics will pull down fourth-quarter earnings results by about 5 cents a share. In January, Target somewhat ambiguously said fourth-quarter earnings would come in below analysts’ then-consensus of 94 cents because of heavy holiday promotions.Buchanan expects a fourth-quarter profit of 87 cents from Target, versus the current consensus for 89 cents. The company earned 91 cents in the year-earlier period.

“Item merchandising this past holiday was exceptional, especially in apparel and home, with the new World Bazaar import program in home inspirational,” Buchanan said.

Kozloff also sees a profit of 87 cents, adding that “there is the potential for a negative earnings surprise should top-line momentum in January not be sufficient to offset the accounting adjustments announced on Feb. 3.”

Wal-Mart Stores Fun Facts

2004 revenues:$284.8 billionEqual to:The 2002 gross domestic product of Austria or six times the annual sales of its closest discounter competition, Target Corp.
Total square footage:Approximately 700 millionRoughly equal to:167 Malls of America.
Plans to open:More than 480 SuperCenters, discount stores, neighborhood markets, Sam’s Clubs and international stores.Which is:Slightly more than one new store opening each day for one year.
Sales associates:1.6 millionAbout equal to:The population of Warsaw, Poland’s capital.
Total customer visits per week:138 millionWhich is about:The number of people who watched the 2003 Super Bowl.
Expected capital expenditure in 2005: $12 billionAbout equal to:The 2002 gross domestic product of Cameroon or Lebanon.

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