NEW YORK — Who else but Wal-Mart Stores Inc. could earn $2 billion in three months and disappoint Wall Street?

This story first appeared in the November 14, 2003 issue of WWD. Subscribe Today.

The world’s largest company again reported double-digit bottom- and top-line growth Thursday, but in a rare misstep, earnings per share missed the Wall Street forecast by a penny and apparel markdowns caused Wal-Mart’s consolidated gross margin to slip for the first time in two years.

Meanwhile, Wal-Mart’s smaller but more fashionable rival, Target Corp., likewise enjoyed substantial bottom- and top-line gains, but continued weakness from its Mervyn’s and Marshall Field’s divisions will likely cause the firm to miss Wall Street’s fourth-quarter consensus estimate.

After failing to meet the analysts’ consensus forecast for the first time since 1996, shares of Wal-Mart tumbled $2.44, or 4.2 percent, to settle at $55.62 in Thursday’s New York Stock Exchange session. Target shares pulled back 93 cents, or 2.3 percent, to end the day at $39.

The flight from Wal-Mart stock came despite a 12.9 percent gain in net income to $2.03 billion, or 46 cents a diluted share, for the three months ended Oct. 31. By comparison, last year the firm had profits of $1.8 billion, or 41 cents.

Earnings were within the firm’s own guidance and gross margin regressed by a comparatively minor 9 basis points, which translates to 0.09 percent, but that still didn’t meet the Bentonville, Ark.-based retailer’s own, as well as analysts’ and investors’, punishingly high standards.

Moreover, the gross margin erosion allowed net sales for the period to slightly outpace bottom-line growth — a no-no at Wal-Mart — as they increased 13.1 percent to $62.48 billion from $55.24 billion a year ago. By division, Wal-Mart stores’ sales grew 12.8 percent to $42.39 billion from $37.57 billion last year, while comparable-store sales improved 5.7 percent. At Sam’s Club, sales rose 11.2 percent to $8.61 billion versus $7.74 billion a year ago and comps jumped 8 percent. The international business did best of all, posting a 15.7 percent gain to $11.49 billion from $9.93 billion in the prior-year quarter.

Taken together, consolidated U.S. comps were up 6.1 percent, but that offered little consolation to chief executive officer Lee Scott.

“With the improvement in the sales trend from the 11 percent reported in the second quarter, I should feel better about the economic environment,” said Scott on a prerecorded conference call with analysts. “However, a lot of the increase was the result of easier comparisons. Last year our comparable sales declined as the year progressed. We have seen some positive momentum off the lows we experienced early this year, but the consumer is still very cautious and probably will remain so until we see further improvements in employment.

“On balance it was a good quarter but not the performance quality seen in the first half of the year. All said,” he concluded, “I don’t think consumer spending is slowing but I also don’t see the strength that many of you in the investment community appear to see.”

As for gross margin, which retreated for the first time in eight quarters, Scott said it was “largely due to the heavy [apparel] markdowns we took in August to clear our summer inventories.” Although the markdowns helped Wal-Mart reduce inventory to “acceptable levels,” Scott cautioned that “customers’ cautious spending results in higher sales for the opening price point products and pressure on our margins will continue.”

Margins declined at Wal-Mart stores and Sam’s Club, but that was partially offset by better gross margin at the international division, added vice chairman Tom Coughlin on the call.

Putting the past aside, Scott brightened in considering the upcoming selling season.

“I am looking forward to the holidays,” he said. “Halloween sell-through was up over last year and early sales of Christmas toys are promising.”

George Strachan, an analyst with Goldman Sachs, trimmed his fiscal 2003 estimate by 1 cent to $2.04, but left the fiscal 2004 estimate unchanged at $2.30. He wrote that, while apparel clearance activity had an erosive effect on margins, “otherwise, the income statement looked solid. We continue to regard Wal-Mart stock as fully valued.”

Lazard Frères & Co. analyst Todd Slater cut his fourth-quarter estimate by a penny to 64 cents, and revised downward fiscal 2003 expectations to $2.04 and fiscal 2004 to $2.34.

“We were surprised by the gross-margin shortfall, as we believed Wal-Mart had successfully cleared out of most of its excess seasonal inventory last quarter, and competitors of Sam’s have indicated that its pricing has not been that aggressive, except in isolated market-by-market cases,” Slater wrote in a note.

Also lowering guidance was Robert Buchanan of A.G. Edwards & Sons, who cut his fourth-quarter estimate by a cent, to 63 cents, assuming a 5 percent increase in comps, a 10-basis-point expansion in gross margin and an essentially flat expense ratio.

“Where did the gross margin expansion go?” asked Buchanan in a note, noting that the benefits of direct sourcing and expense control were outweighed by apparel markdowns.

For the nine months, net income grew 16.3 percent to $6.33 billion, or $1.44 a diluted share, from $5.45 billion, or $1.22, a year ago.

Net sales increased 11.4 percent to $181.84 billion from $163.22 billion a year ago. Consolidated domestic comps grew 3.9 percent, comprised of a 3.7 percent gain at Wal-Mart stores and a 4.6 percent increase at Sam’s Club.

Minneapolis-based Target said that, for the quarter ended Nov. 1, net income grew 8.7 percent to $302 million, or 33 cents a diluted share, which matched the Wall Street forecast. By comparison, last year the firm recorded profits of $277 million, or 30 cents.

Consolidated net revenues gained 10.7 percent to $11.29 billion from $10.19 billion a year ago. That consisted of a 10.7 percent increase in retail sales to $10.94 billion from $9.88 billion last year, and an 11 percent rise in net credit card revenues to $344 million from $310 million a year ago. Total company same-store sales increased 4.3 percent.

Target stores, however, were once again critical to the results as Mervyn’s and Marshall Field’s failed to match the flagship division’s performance. Although pretax profit at Target stores rose 12.5 percent to $604 million from $537 million a year ago, that was partially offset by a 41.8 percent plunge in pretax earnings at Mervyn’s to $31 million and a 54.7 percent plunge at Marshall Field’s to $15 million. Fortunately for Target, credit card operations also aided the bottom line, contributing $162 million in pretax earnings, a 22.7 percent improvement over last year.

Corporate revenues were also carried by Target stores, where sales improved 13.9 percent to $9.64 billion and comps gained 6.7 percent. Conversely, Mervyn’s sales fell 10.1 percent to $825 million with an 11.1 percent drop in comps, while Marshall Field’s posted a 6.3 percent retreat in sales to $634 million as comps slumped 4.9 percent.

The ongoing problems with the department stores led chief executive officer Robert Ulrich to warn investors on a conference call that Target is “likely to fall modestly short” of Wall Street’s fourth-quarter consensus estimate of 90 cents.

“Looking forward, for the corporation overall we have tempered our outlook for the fourth quarter and total year in light of recent sales and operating trends at both Mervyn’s and Marshall Field’s,” said Ulrich on the call. “We are actively pursuing merchandising and marketing initiatives at both these divisions that are intended to drive increased guest traffic and improve sales and financial results.”

However, despite being hobbled by the department store group, Goldman Sachs’ Strachan said Target Corp.’s remains a “top pick” and a “core high-quality growth holding.” He did, however, raise the “L-word” in connection with Mervyn’s.

“Is liquidation the end game for Mervyn’s?” asked Strachan in a research note. “If results don’t improve versus last year’s poor fourth quarter, the cash flow argument for keeping the division weakens. With no obvious buyers, liquidation may be the most likely outcome for the unit.”

A.G. Edward’s Buchanan, however, said that he sees the wider corporation being saddled with the underperforming units for the foreseeable future.

“We’d love to upgrade this name in view of our belief that the core business of Target stores will participate in the evolving revival in consumer spending,” wrote Buchanan, despite maintaining “our longstanding ‘hold’” based on Mervyn’s and Marshall Field’s likelihood of remaining in the fold.

Overall, for the nine months, Target said net income grew 4.4 percent to $1 billion, or $1.10 a diluted share, from $966 million, or $1.06, a year ago. Total revenues increased 9.2 percent to $35.59 billion from $29.86 billion last year.

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