Wal-Mart Should Keep Close Watch on Food Cost Inflation

Wal-Mart (NYSE:WMT) is the world’s largest retailer, competing with companies like Target (NYSE:TGT), Costco (NASDAQ:COST), Amazon (NASDAQ:AMZN) and Best Buy (NYSE:BBY). The retailer sells almost every variety of merchandise, but is most dependent on grocery products.

Our price estimate for Wal-Mart stands at $65.42 which is about 17% above market price. We estimate that Wal-Mart generates 62% of its stock value from its flagship U.S. stores.

We recently examined the increasing competitive push in the grocery sector from retailers like CVS, Walgreens and Target (see Grocery Wars Could Pose Risk to Wal-Mart Stock Upside). Beyond these retail chains, Wal-Mart also competes with grocery stalwarts like Safeway, Krogers and Whole Foods. Wal-Mart has significant exposure to this segment with over 50% of its sales attributable to groceries.

Apart from increasing competition, another cause of concern in the grocery sector is food inflation. Given Wal-Mart’s high exposure to groceries, the retailer may need to seek cost cuts to mitigate the impact. While the food inflation trend affects all grocery retailers, we highlight the impact on Wal-Mart’s outlook below.

Wal-Mart sales breakup for 2009

Food Inflation

Goldman Sachs notes that commodity food prices have risen significantly over the past few months. In the words of Andrew Tilton, head economist at Goldman Sachs –

Data from the United States Department of Agriculture (USDA) suggests a similar trend. According to the latest reports, prices for commodities like wheat and oil crops are on the rise. The chart below depicts price for wheat received by farmers, as cited in a report published by the USDA. ^[1]

Soybean prices are also expected to rise due to a lower expected stock and higher demand. ^[2]. Additionally, prices for retail meat also appear to have increased. According to the USDA, higher farm commodity costs have found their way into retail prices over the past few months. ^[3]

Further, the supply of cattle is expected to remain light over the next few years. ^[4] Wal-Mart mentioned in its last earnings transcript that it has already witnessed inflation in meat and dairy categories.

There is, of course, a time lag between growth in commodity costs and when these costs are passed along to consumers through retail price increases (typically a few months). Moreover, the effect is diminished as several other costs come into play. Nonetheless, a continued trend in commodity food inflation is something that Wal-Mart must keep on its radar.

Impact on Wal-Mart

Wal-Mart realistically has 3 options in regard to rising commodity costs. Either the company will pass these on to customers, absorb the costs (putting pressure on profit margins) or increase its supply chain efficiency to offset the costs (effectively shielding both margins and retail prices).

Its recent move to stock more produce from local farmers could be indicative of Wal-Mart’s effort to mitigate the impact of rising commodity prices. ^[5] Given that more than 50% of Wal-Mart’s sales come from groceries, its margins could be at stake if it doesn’t raise prices. We believe that price rises may not be the most viable solution in light of the increasing push from competitors into the grocery segment.

Drag the trend line in the modifiable chart below to see the affect of various gross margin scenarios on Wal-Mart’s stock value.

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1. Wheat Outlook, United States Department of Agriculture, Jan 14 2011 [↩]
2. Oil Crops Outlook, United States Department of Agriculture, Jan 13 2011 [↩]
3. Retail Meat Prices Climb In November, Leading Food Inflation Trend, cattlenetwork.com, Dec 15 2010 [↩]
4. Livestock, Dairy and Poultry Outlook, United States Department of Agriculture, Jan 19 2011 [↩]
5. Wal-Mart to Stock Healthier, More Affordable Foods, Bloomberg, Jan 21 2011 [↩]