What’s Impacting Wal-Mart’s Gross Margins?

Wal-Mart is the pioneer of modern supply chain management with strong focus on vendor partnerships, distribution, and inventory management. The retailer employs strategies such as cross docking, vendor managed inventory and RFID (radio frequency identification) to maintain a firm control over purchase, transportation and storage of merchandise. ^[1] This allows it to buy products at low prices and reduce the intermediate storage and inventory carrying costs.

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Wal-Mart’s Efficient Supply Chain Helps Sustain Its Gross Margins

Due to its large size, Wal-Mart enjoys strong negotiating power over its vendors. The retailer offers long-term and high-volume purchase contracts to its vendors and is therefore able to negotiate the best prices. Several vendors are entirely dependent on Wal-Mart for their business, which allows the retailer to squeeze the best possible agreement from them. For distribution purposes, it uses the technique of cross docking to reduce or in some cases eliminate the intermediate storage costs. ^[2] Cross docking refers to the direct transfer of goods from vendor end to warehouses without any storage in between. Wal-Mart receives goods from its vendors at loading docks and its massive fleet of trucks take these to the warehouses, which are usually located in the range of 130 miles from the stores. ^[3]

Wal-Mart employs VMI, or vendor managed inventory method, where its suppliers are responsible for managing their goods inside the retailer’s warehouses. ^[2] As a result, inventory management becomes stronger and more vendor specific, which results in 100% order fulfillment. In 2003, the company installed RFID (radio frequency identification) in its warehouses to track the movements of pallets and help employees quickly identify goods that have fallen below the safety stock level. ^[4] These strategies prevent the issues of inventory shortage or surplus, which helps in reducing the cost of goods and services.

The efficient supply chain has allowed Wal-Mart to become the price leader in the U.S. retail market. Although it is well known strategy how the retailer achieved it, copying the model is not easy because of the high initial costs and huge inventory levels involved.

Growing Share Of Groceries Will Put A Downward Pressure

Since consumer spending on groceries is non-discretionary and therefore less correlated to the macroeconomic factors, it has been one of the prime focus areas for Wal-Mart. The company has been aggressively converting its Discount Stores to Supercenters that offer a complete range of grocery items. Additionally, it has been increasing the number of grocery SKUs in its existing stores and launching in-house brands such as Great Value, which are cheaper than national brands but comparable in quality. As a result, the share of groceries in Wal-Mart’s total revenues has jumped from 24% in 2002 to 55% currently. ^[5] However, groceries is a low margin business and has led to some pressure on the company’s gross margins.

Going forward, we expect Wal-Mart to continue the push into groceries as it expands its smaller format Express Stores and Neighborhood Markets in urban areas. Although these stores offer a limited number of SKUs, most of them are grocery items. Last year, the retailer opened 76 such stores and plans to add another 100 this year. ^[6] Since the company only had 286 smaller format stores at the end of 2012 and some of the dollar stores operate as much as 10,000 stores in the U.S., we see a lot of potential for growth. On the other hand, the expansion of larger formats that offer other categories along with groceries is likely to be slow as Wal-Mart is nearing a saturation point in the U.S. The growing share of groceries will remain a drag on the retailer’s gross margins in the future.

Rising Labor Costs In China Will Weigh On The Margins

More than 80% of Wal-Mart’s vendors are located in China where rising labor costs are undermining the retailer’s strong negotiating power. This has resulted in higher production costs which has negatively impacted the gross margins. Due to labor shortages, an aging population and government regulations, there has been a substantial rise in China’s labor costs. The development of rural areas has encouraged the local population to look for work opportunities in their vicinity. This is preventing migration to urban areas, resulting in less and expensive labor. About 243 million Chinese are expected to be above the age of 60 by 2020, which will further add to the labor shortage. ^[7]

Additionally, the Chinese government’s regulations require minimum wages to be raised every two years. ^[8] Back in 2001, the minimum wage in China was about $58 cents per hour and has increased by almost 20% annually for a decade. ^[9] China no longer remains a low cost destination for Wal-Mart and the retailer may have to look at other countries such as Vietnam, Cambodia etc. for its goods. ^[10] However, given the size of Wal-Mart’s vendor network in China, it will not be easy.

How Does A Change In Gross Margins Impact Wal-Mart’s Stock?

We currently forecast margins will continue to decline for the next couple of years and stabilize at around 26% as Wal-Mart further diversifies its supply chain network. However, if its growing grocery business and rising labor costs drag the figure down to 24.50% by the end of our Trefis forecast period, there can be 5%-10% downside to our price estimate for Wal-Mart. At this point, we believe it is unlikely that the company’s gross margins will improve going forward.

Our price estimate for Wal-Mart stands at $81, implying a premium of 10% to the market price.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Walmart’s Keys to Successful Supply Chain Management, University of San Francisco [↩]
2. Wal-Mart Used Technology To Become Supply Chain Leader, Arkansas Business, Jul 2 2012 [↩] [↩]
3. How Much More ‘Blood’ Can Wal-Mart Squeeze From Its Supplier Base, Supply Chain Brain, Oct 18 2012 [↩]
4. Walmart Expands RFID Mandate, RFID Journal, Aug 18 2003 [↩]
5. Wal-Mart’s SEC filings [↩]
6. Wal-Mart’s Q4 fiscal 2013 earnings transcript, Feb 25 2013 [↩]
7. China’s bid to provide care systems for elderly faces hurdles, warn experts, South China Morning Post, Sept 4 2013 [↩]
8. China Initiates New Rounds Of Minimum Wage Increases, China Briefing, Jan 4 2013 [↩]
9. China Manufactures Survive by Moving to Asian Neighbors, The Wall Street Journal, May 1 2013 [↩]
10. China Labor Cost Rise To Boost Rivals In Asia, CNBC, Jan 17 2013 [↩]