Wal-Mart Needs To Enhance Its Focus On Small Stores In Wake Of Tepid Q1 Results

After a lackluster holiday quarter, Wal-Mart‘s (NYSE:WMT) growth disappointed once again as its Q1 fiscal 2015 earnings fell short of consensus estimates. The retailer’s U.S. comparable sales (-0.2%) fell for the fifth consecutive quarter and its profits declined by 5% as compared to the same quarter last year. The company stated that its sales and profitability were mainly impacted by adverse weather conditions that prevented store visits, hindered supply chain operations and drove operating expenses higher than expected. ^[1] Additionally, food stamp cuts and foreign currency fluctuations also had a negative impact on Wal-Mart’s results. About 20% of the retailer’s customers use food stamps at Wal-Mart stores instead of cash and the reduction in SNAP benefits by the government meant a decline in average transaction amount. ^[2] In international markets, while the retailer’s sales increased by 3.4% on a constant currency basis, they declined 1.4% after factoring in the exchange rate impact.

In addition to the aforementioned factors, Wal-Mart’s results were also impacted by a deeper economic problem. Despite a relatively better economic scenario, medium-low end customers still remain cautious with their spending. This indicates that the retailer’s struggle is likely to continue in the near future, which is evident from its bleak second quarter guidance. Hence, Wal-Mart needs to enhance its focus on alternate channels—small stores and e-commerce—to revive its growth. While both these channels have done very well in the recent past, they have been unable to boost the company’s results due to their immaterial size. Therefore, we believe that Wal-Mart needs to be proactive in expanding its small store channel (Wal-Mart Express & Neighborhood markets), for which it can consider buying Family Dollar. Although the company is planning to ramp-up its investments in its e-commerce channel to maintain a strong growth momentum, it is unlikely to have a noticeable impact on Wal-Mart’s results any time soon given its scant 2% revenue contribution.

Our price estimate for Wal-Mart stands at $79.30, which is less than 5% ahead of the market price. However, we are in the process of updating our model in light of the recent earnings release.

See our complete analysis for Wal-Mart

Expand Smaller Stores Aggressively

Traditionally, Wal-Mart has been serving customers who make less frequent stock-up trips, with its large stores located on the outskirts of a city. It hasn’t been as effective in catering to buyer needs for easy access, for which they usually go to a traditional convenience store. As a result, local convenience, dollar and grocery stores have been nibbling Wal-Mart’s low-end customer base. Expanding its smaller format network provides Wal-Mart with a great opportunity to win back those customers. By providing them with fresh inventory of food, consumables and other essential merchandise, the retailer can drive customers from alternative stores to its Neighborhood markets and Express outlets.

During the first quarter, while Wal-Mart’s Supercenters were struggling with low store traffic on account of harsh weather, Neighborhood markets registered 5% growth in comparable sales driven by 4% increase in traffic. ^[1] Interestingly, these stores delivered similar comparable sales growth in the previous quarter as well, when the weather wasn’t best suited for store shopping. While performance of small stores is promising, their limited presence (400 stores) is preventing Wal-Mart from benefiting from their robust growth.

Therefore, the retailer looking to expand these formats aggressively to make small store channel a valuable growth driver. In October last year, Wal-Mart unveiled plans to open 120-150 small stores, and 115 Supercenters in fiscal 2015. Soon after, the company uplifted its expansion plans to about 270-300 small stores in the U.S in fiscal 2015. During the quarter, Wal-Mart opened 13 Neighborhood markets and was on track to open 180-200 Neighborhood markets and 90-100 Express stores by the year end. ^[1] As the quarter ended, the company entered the third test phase of its Wal-Mart Express stores, in which it will tether these stores to a nearby Supercenter. Doing so will enable an Express store to order desired inventory from a Supercenter and receive it on the same day. This will allow Express stores to offer products that require larger storing space such as bicycles, swimming pools etc. ^[1]

Consider Family Dollar Acquisition For Bolstering Small Store Network

Although Wal-Mart is looking to expand its small stores aggressively, the widespread network of dollar stores and space constraints in urban areas can be a roadblock. To prevent this, Wal-Mart can consider buying one of the dollar chains. Earlier this year, industry expert and Credit Suisse analyst Micheal Exstein had advised Wal-Mart’s CEO to acquire Family Dollar. ^[3] Although the company hasn’t shown any such intentions so far, buying Family Dollar makes sense considering that smaller store expansion is Wal-Mart’s priority at the moment. With Family Dollar’s market capitalization of $7.4 billion and revenues of roughly $10 billion, it would be a small transaction for Wal-Mart, for which it will receive 7,500 stores across the nation. Out of all the three dollar chains, Family Dollar has the minimum locations of store overlaps with Wal-Mart, which makes it the most viable acquisition option. According to Exstein’s report, only 19% of Wal-Mart stores are within one mile radius of a Family Dollar store. On the other hand, this figure is 29% in case of Dollar General and 49% in case of Dollar Tree.

Buying Family Dollar will give Wal-Mart an already setup network of smaller stores with fewer concerns of self-cannibalization. Moreover, it will reduce the retailer’s potential competition considerably in urban markets. If Wal-Mart buys Family Dollar, its smaller format network can start contributing significantly a lot sooner. However, buying a dollar chain is a big decision and it will be interesting to see if the company comes up with any such plans in the future.

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1. Wal-Mart’s Q1 fiscal 2015 earnings transcript, May 15 2014 [↩] [↩] [↩] [↩]
2. Wal-Mart sales growth weakest in 5 years, outlook disappoints, Reuters, May 16 2014 [↩]
3. Why Wal-Mart Should Buy Family Dollar, Financial Post, Feb 19 2014 [↩]