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Wal-Mart's Midlife Crisis


By Anthony Bianco COVER STORY PODCAST

John E. Fleming, Wal-Mart's newly appointed chief merchandising officer, is staring hard at a display of $14 women's T-shirts in a Supercenter a few miles from the retailer's Bentonville (Ark.) headquarters. The bright-hued stretch T's carry Wal-Mart's own George label and are of a quality and stylishness not commonly associated with America's über-discounter. What vexes Fleming is that numerous sizes are out of stock in about half of the 12 colors, including frozen kiwi and black soot.

Fleming may be America's most powerful merchant, but a timely solution is beyond him even so. Wal-Mart failed to order enough of these China-made T-shirts last year, and so they and other George-brand basics will remain in short supply in most of its 3,443 U.S. stores until 2007's second half, depriving the retailer of tens of millions of dollars a week it sorely needs. "The issue with apparel is long lead times," says the quietly intense Fleming, who spent 20 years at Target Corp. (TGT) before joining Wal-Mart Stores Inc. (WMT) "We will get it fixed."

For nearly five decades, Wal-Mart's signature "everyday low prices" and their enabler—low costs—defined not only its business model but also the distinctive personality of this proud, insular company that emerged from the Ozarks backwoods to dominate retailing. Over the past year and a half, though, Wal-Mart's growth formula has stopped working. In 2006 its U.S. division eked out a 1.9% gain in same-store sales—its worst performance ever—and this year has begun no better. By this key measure, such competitors as Target, Costco (COST), Kroger (KR), Safeway (SWY), Walgreen's (WAG), CVS, and Best Buy (BBY) now are all growing two to five times faster than Wal-Mart.

Wal-Mart's botched entry into cheap-chic apparel is emblematic of the quandary it faces. Is its alarming loss of momentum the temporary result of disruptions caused by transitory errors like the T-shirt screwup and by overdue improvements such as the store remodeling program launched last year? Or is Wal-Mart doing lasting damage to its low-budget franchise by trying to compete with much hipper, nimbler rivals for the middle-income dollar? Should the retailer redouble its efforts to out-Target Target, or would it be better off going back to basics?

If Wal-Mart seems short of answers at the moment, it might well be because there aren't any good ones. Increasingly, it appears that America's largest corporation has steered itself into a slow-growth cul de sac from which there is no escape. "There are a lot of issues here, but what they add up to is the end of the age of Wal-Mart," contends Richard Hastings, a senior analyst for the retail rating agency Bernard Sands. "The glory days are over."

Simple mathematics suggest that a 45-year-old company in an industry growing no faster than the economy as a whole will struggle to sustain the speedy growth rates of its youth. In Wal-Mart's case, this difficulty is exacerbated by its great size and extreme dominance of large swaths of the U.S. retail market. Wal-Mart already controls 20% of dry grocery, 29% of nonfood grocery, 30% of health and beauty aids, and 45% of general merchandise sales, according to ACNielsen.

However, the expansion impulse is as deeply embedded in Wal-Mart's DNA as its allegiance to cut-rate pricing. Wal-Mart was able to boost total U.S. revenues by 7.2% last year by opening new stores at the prodigious rate of nearly one a day. According to Wal-Mart CEO H. Lee Scott Jr., the company plans to sustain this pace for at least the next five years. In fact, he is on record saying that room remains in the U.S. for Wal-Mart to add 4,000 Supercenters—the largest of its store formats by far—to the 2,000 it now operates.

Does Scott, 58, recognize any limits whatsoever to Wal-Mart's growth potential in the U.S., which accounted for 78% of its $345 billion in sales last year? "Actually, and I know it's going to sound naive to you, I don't," he replies. "The real issue is, are [we] going to be good enough to take advantage of the opportunities that exist?"

TOO CLOSE FOR COMFORT

Wall Street does not share Scott's bullishness, to put it mildly. Wal-Mart shares are trading well below their 2004 high and have dropped 30% in total since Scott was named CEO in 2000, even as the Morgan Stanley (MS) retail index has risen 180%. "The stock has been dead money for a long time," says Charles Grom, a JPMorgan Chase & Co. (SPM) analyst.

Even money managers who own Wal-Mart's shares tend to see the retailer as a beaten-down value play, not a growth company. "I'd be surprised if true growth-oriented investors were involved at this point," says Walter T. McCormick, manager of the $1.2 billion Evergreen Fundamental Large Cap Fund, which began buying the stock a year ago. "The issue the Street has is market saturation: We may be in the seventh inning of a nine-inning game."

One can argue that the deceleration of Wal-Mart's organic growth is a function of the aging of its outlets, given that same-store sales rates slow as stores mature. Outlets five years or older accounted for 17% of all U.S. Supercenters in 2000 and 44% in 2006, and will top 60% in 2010, according to HSBC (HBC) analyst Mark Husson. "There's an inevitability of bad middle age," he says.

Meanwhile, the underlying economics of expansion have turned against Wal-Mart, even as it relies increasingly on store-building to compensate for sagging same-store sales. On balance, the new Supercenters are just not pulling in enough sales to offset fully the sharply escalating costs of building them. Part of the problem is that many new stores are located so close to existing ones that Wal-Mart ends up competing with itself. All in all, the retailer's pretax return on fixed assets, which includes things such as computers and trucks as well as stores, has plunged 40% since 2000.

Even many analysts with a buy on Wal-Mart want it to follow the lead of McDonald's Corp. (MCD) and cut way back on new-store building to concentrate instead on extracting more value from existing stores, which vary wildly in their performance. Wal-Mart disclosed a year and a half ago that same-store sales were rising 10 times, or 1,000%, faster at the 800 best-managed outlets than at the 800 worst-run ones. Equally shocking was its admission that 25% of its stores failed to meet minimum expectations of cleanliness, product availability, checkout times, and so on.

Scott is acutely aware of the Street's discontent. "We have to find a way to give our shareholders back the returns that they need through some mechanism," he acknowledges. In March, Wal-Mart boosted its dividend 31%. Apparently, the board also is considering spinning off Sam's Club, the warehouse club division that is a perennial also-ran to Costco.

Wal-Mart announced late last year that it would trim its customary 8% annual addition to U.S. square footage to 7% in 2007. At the moment, though, slamming on the brakes is out of the question. Says Scott: "If you stop the growth at Wal-Mart, you'd be silly to think that [alone] means you're going to have better stores."

Wal-Mart's "home office" has taken a series of steps to improve the performance of its far-flung store network. Last year it implemented a whole new supervisory structure that required many of its 27 regional administrators to move out of Bentonville and live in the districts they manage. In April, Scott removed the executive in charge of U.S. store operations and put her in charge of corporate personnel instead.

The number of stores falling below the threshold of minimum customer expectations has declined but remains "more than would be acceptable," says Scott, who is surprisingly philosophical about the persistence of mediocrity. Asked why it has been so difficult to fix bad stores, HE replies: "That's a very good question. It's a question I ask all the time."

The polite, self-deprecating Scott is no Robert L. Nardelli, whose ouster as Home Depot Inc.'s (HD) chief had as much to do with his abrasive personality as the chain's business problems. That said, Wal-Mart's stock has performed worse under Scott than Home Depot's did under Nardelli. "The Street is going to look to the back half of 2007 for evidence of improvement," says an adviser to a large, longtime Wal-Mart shareholder. "If that doesn't happen, you're going to see a tremendous amount of pressure."

Scott & Co. already are struggling to cope with mounting sociopolitical backlash to Wal-Mart's size and aggressive business practices. Over the past decade, dozens of lawsuits were brought by employees claiming to be overworked and underpaid, including the mother of all sex discrimination class actions. Organized labor set up two Washington-based organizations to oppose the antiunion employer at every turn (see BusinessWeek.com, 4/9/07, "Stop the Bullying, Wal-Mart"). And hundreds of municipalities across the country erected legal obstacles of one kind or another.

Wal-Mart's initial reaction to the gathering storm of opposition was to ignore it and maintain the defiant insularity that is a legacy of its Ozarks origins. "The best thing we ever did was hide back there in the hills," Sam Walton, the company's legendary founder, declared shortly before his death in 1992.

In the past few years, Scott has reluctantly brought Wal-Mart out from behind its Bentonville barricades. Virtually from scratch, this famously conservative company has built a large public and government relations apparatus headed by Leslie A. Dach, a veteran Washington political operative of pronounced liberal bent. Few CEOs have embraced environmental sustainability as avidly as has Scott, who also broke with the Republican orthodoxy of his predecessors by advocating a hike in the federal minimum wage.

It's not just rhetoric: Wal-Mart has indeed made substantive reforms in some areas. It has struck up effective working relationships with many of the very environmental groups it once disdained. No less dramatically, the company has added three women (one is Hispanic) and two African American directors to its board and also tied all executive bonuses to diversity goals.

It turns out, though, that there is a dark, paranoid underside to Wal-Mart's visible campaign of outreach. What began as an attempt by Wal-Mart's Threat Research and Assessment Group to detect theft and pro-union sympathies among store workers grew into surveillance of certain outside critics, consultants, stockholders, and even Wal-Mart's board. Bruce Gabbard, a security technician fired for allegedly unauthorized wiretapping of a New York Times reporter, has described himself as "the guy listening to the board of directors when Lee Scott is excused from the room."

Wal-Mart's spreading Spygate scandal is perhaps the most damaging in a long sequence of PR disasters, including last year's conviction of former No. 2 executive Thomas M. Coughlin on fraud and tax evasion charges stemming from embezzlement of company funds. Coughlin, a Walton protégé who had been Scott's leading rival for the CEO post, is serving a sentence of 27 months of house arrest.

There is no way of measuring how much business Wal-Mart is losing to competitors with more benign reputations. According to a recent survey conducted by Wal-Mart itself, though, 14% of Americans living within range of one of its stores—which takes in 90% of the population—are so skeptical of the company as to qualify as "conscientious objectors."

But the Arkansas giant's fundamental business problem is that selling for less no longer confers the overwhelming business advantage it once did. Low prices still define the chain's appeal to its best customers, the 45 million mostly low-income Americans who shop its stores frequently and broadly. But the collective purchasing power of these "loyalists," as Wal-Mart calls them, has shriveled in recent years as hourly wages have stagnated and the cost of housing and energy have soared.

More affluent shoppers also walk Wal-Mart's aisles in great numbers, but they tend to buy sparingly, loading up on toothpaste, detergent, and other "consumables" priced barely above cost while shunning higher-margin items such as clothes and furniture. To the selective middle-income shopper, quality, style, service, and even store aesthetics increasingly matter as much as price alone. "Here's the big thought Wal-Mart missed: Price is not enough anymore," says Todd S. Slater, an analyst at Lazard Capital Markets.

BACKWOODS KNOWHOW

At first, Wal-Mart management blamed its loss of momentum mostly on rising gasoline prices—a theory undercut when same-store sales kept falling even as the cost of gas receded during the latter half of 2006. Today, Wal-Mart executives are more willing to acknowledge the X factor of intensified competition. Says Fleming: "We're now up against world-class competitors that are each taking a slice of our business."

Wal-Mart not only was slow to recognize this threat but also responded haphazardly once it did. The nub of the problem was that the discounter had relied for so long on selling for less that it did not know any other way to sell. Wal-Mart did not begin to build a marketing department worthy of the name until Fleming was named to the new position of chief marketing officer in spring, 2005, an appointment Scott hailed as "an extraordinary move for us."

Founded in 1962, Wal-Mart rose to dominance on the strength of its mastery of retailing's "back-end" mechanics. Forced by the isolation of the Ozarks to do for itself what most retailers relied on others to do for them, Wal-Mart built a cutting-edge distribution system capable of moving goods from factory loading dock to store cash register faster and cheaper by far than any competitor. It added to its cost advantage by refusing to acquiesce to routine increases in wholesale prices, continually pressing suppliers to charge less.

Walton, who was both a gifted merchant and a born tightwad, also pinched pennies in every other facet of business, from wages and perks (there were none) to fixtures and furnishings. Aesthetics counted for so little that when the retailer finally put down carpet in its stores it took care to choose a color that matched the sludgy gray-brown produced by mixing dirt, motor oil, and the other contaminants most commonly tracked across its floors. To Wal-Mart, the beauty of its hideous carpet was that it rarely needed cleaning.

Low costs begat low prices. Instead of relying on promotional gimmickry, Wal-Mart sold at a perpetual discount calculated to make up for in volume what it lost in margin. Walton's philosophy was price it low, pile it high, and watch it fly. His belief in everyday low prices made him a populist hero even as he built America's largest fortune. (His descendants still own 40% of Wal-Mart's shares, a stake worth $80 billion.) Regulators forced "Mr. Sam" to modify his slogan of "Always the lowest price" to the hedged "Always low prices!" But hundreds of retailers went broke trying to compete with Wal-Mart on price just the same.

In many ways, Wal-Mart has remained reflexively tight-fisted under Scott, a 28-year company veteran who trained at Walton's knee and rose to the top through trucking and logistics. Last year, Wal-Mart began remodeling the apparel, home, and electronics sections in 1,800 stores, replacing miles of that stain-colored carpeting with vinyl that looks like wood. To Fleming, the new "simulated wood" floor is all about aesthetic improvement. His boss takes the classical Wal-Mart view. "The truth is that vinyl costs less," Scott says. "And the maintenance on the vinyl costs less than the maintenance on the carpet."

Yet Wal-Mart is neither as low-cost nor as low-price a retailer as it was in Walton's day, or even when Scott moved up to CEO. Most dramatically, overhead costs jumped 14.8% in 2006 alone and now amount to 18.6% of sales, compared with 16.4% in Scott's first year—a momentous rise in a business that counts profit in pennies on the dollar.

The imperatives of reputational damage control have prompted Bentonville to add hundreds of staff jobs in public relations, corporate affairs, and other areas that the company happily ignored when it was shielded by the force field of Walton's folksy charisma. And as the nation's largest electricity consumer and owner of its second-largest private truck fleet, Wal-Mart was hit doubly hard by the explosion of energy costs.

Wal-Mart also has purposefully, if not entirely voluntarily, inflated its cost base in expanding far beyond its original rural Southern stronghold. It is far more expensive to buy land and to build, staff, and operate stores in the large cities that are the final frontier of Wal-Mart's expansion than in the farm towns where it began. Then, too, the company is encountering mounting resistance as it pushes deeper into the Northeast, Upper Midwest, and West Coast, requiring it to retain legions of lawyers and lobbyists to fight its way into town.

NARROWING THE GAP

Under Scott, Wal-Mart even blunted its seminal edge in distribution by letting billions of dollars in excess inventories accumulate at mismanaged stores. A dubious milestone was reached in 2005 as inventories rose even faster than sales. "You'd see these big storage containers behind stores, but what was more amazing was that [local] managers were going outside Wal-Mart's distribution network to subcontract their own warehouse space," says Bill Dreher, a U.S. retailing analyst for Deutsche Bank (DB).

Over the past decade, top competitors in most every retailing specialty have succeeded in narrowing their cost gap with Wal-Mart by restructuring their operations. They eliminated jobs, remodeled stores, and replaced warehouses, investing heavily in new technology to tie it all together. Unionized supermarkets even managed to chip away at Wal-Mart's nonunion-labor cost advantage, signaling their resolve by taking a long strike in Southern California in 2003-04. The end result: Rival chains gradually were able to bring their prices down closer to Wal-Mart's and again make good money.

Consider the return to form of Kroger Co., the largest and oldest U.S. supermarket chain. Cincinnati-based Kroger competes against more Wal-Mart Supercenters—1,000 at last count—than any other grocer. Which is why until recently the only real interest Wall Street took in the old-line giant was measuring it for a coffin. Today, though, a rejuvenated Kroger is gaining share faster in the 32 markets where it competes with Wal-Mart than in the 12 where it does not.

A recent Bank of America (BAC) survey of three such markets—Atlanta, Houston, and Nashville—found that Kroger's prices were 7.5% higher on average than Wal-Mart's, compared with 20% to 25% five years ago. This margin is thin enough to allow Kroger to again bring to bear such "core competencies" as service, quality, and convenience, says BofA's Scott A. Mushkin, who recently switched his Kroger rating to buy from sell. "We're saying the game has changed, and it looks like it has changed substantially in Kroger's favor," he says.

While Wal-Mart vies with a plethora of born-again rivals for the trade of middle-income Americans, it also must contend on the low end of the income spectrum with convenience and dollar-store chains and with such "hard discounters" as Germany's Aldi Group. These no-frills rivals are challenging Wal-Mart's hold over budget-minded shoppers by underpricing it on many staples.

To right Wal-Mart's listing U.S. flagship division, Scott installed Eduardo Castro-Wright as its president and CEO in fall, 2005. The Ecuador-born, U.S.-educated Castro-Wright, now 51, worked for RJR Nabisco and Honeywell International Inc. (HON) before joining Wal-Mart in 2001. In Castro-Wright's three years as CEO of Wal-Mart Mexico, revenues soared 50%, powered by sparkling same-store sales growth of 10% a year.

To date, Castro-Wright has fallen so far short of replicating the miracle of Mexico that in January he had to publicly deny rumors that he was about to be transferred back to international. Instead, Scott shifted the vice-chairman over Castro-Wright to new duties. That the U.S. chief now reports directly to Scott both solidifies Castro-Wright's status and ups the pressure on him to show results.

Castro-Wright can point to progress on the cost side of the ledger. By tightening controls over the stores, headquarters has halved the growth rate of inventories to 5.6% from 11.5% two years ago. Wal-Mart also has squeezed more productivity out of its 1.3 million store employees for eight consecutive quarters. This was done by capping wages for most hourly positions, converting full-time jobs to part-time ones, and installing a sophisticated scheduling system to adjust staffing levels to fluctuations in customer traffic.

Wal-Mart has found other new ways to economize, notably by cutting out middlemen to do more contract manufacturing overseas. The company's much publicized green initiatives have tempered criticism from some left-leaning opponents but are perhaps best understood as a politically fashionable manifestation of its traditional cost-control imperative.

By any conventional measure, Wal-Mart remains a solidly profitable company. Rising overhead costs have cut into net income, which in 2006 rose a middling 6.7%, a far cry from the double-digit increases of the 1990s. Return on equity continues to top 20%, however, and U.S. operating margins actually have widened a bit under Castro-Wright, as costs have risen a bit slower than Wal-Mart's average selling price.

Evidently, though, it is going to take a lot more than Castro-Wright's workmanlike adjustments to revive Wal-Mart's moribund stock. In the end, Scott's aversion to a McDonald's-style strategic about-face leaves Wal-Mart no alternative but to try to grow its way back into Wall Street's good graces. But if opening a new Wal-Mart or Sam's Club almost every day can't move the dial, what will?

Foreign markets present an intriguing mix of potential and peril for Wal-Mart, which first ventured abroad in 1992. Although the company now owns stores in 13 countries, the lion's share of those revenues comes from Mexico, Canada, and Britain. In 2006 international revenues rose 30%, to $77 billion. At the same time, though, Wal-Mart's long-standing struggles to adapt its quintessentially American low-cost, low-price business model to foreign cultures was underscored by the $863 million loss it took in exiting Germany.

Wal-Mart is the rare U.S. company that is more politically constrained at home than abroad in angling for outsize growth opportunities. In March it withdrew its application for a Utah bank charter just before a congressional committee was set to convene hearings. The retreat marks an apparent end to its decade-long campaign to diversify into consumer banking.

Although Wal-Mart regularly makes sizable acquisitions abroad, it is in no position to respond in kind to such domestic dagger thrusts as CVS's $26.5 billion acquisition of pharmacy benefits manager Caremark Rx. "That deal is a real threat, but Wal-Mart would have huge antitrust problems if it made an acquisition of any size," says a top mergers-and-acquisitions banker. "They are kind of stuck."

In the end, Wal-Mart seems unlikely to regain its stride unless it can solve what might be the diciest conundrum in retailing today. That is, can it seduce tens of millions of middle-income shoppers into stepping up their purchases in a major way without alienating its low-income legions in the process?

Largely because of the pressing need to differentiate itself from Wal-Mart, Target began grappling with this very puzzle more than a decade ago and gradually solved it with the cheap-chic panache that transformed it into "Tar-zhay." Says the president of a leading apparel maker: "Target has an awareness of what's happening in fashion equal to a luxury player, maybe greater. They have set the bar very high."

Scott acknowledged as much in making former Target exec Fleming chief marketing officer, reporting to Castro-Wright. Fleming, who had been CEO of Wal-Mart.com, went outside to fill every key slot in building a 40-person marketing group from scratch. He supported Wal-Mart's move into higher-priced, more fashionable apparel and home furnishings with the splashiest marketing the retailer had ever done, buying ad spreads in Vogue and sponsoring an open-air fashion show in Times Square.

Wal-Mart's top management all the way up to and including Scott presumed that Wal-Mart could run like Tar-zhay before it had learned to walk. "What Wal-Mart tried to do smacks of a kind of arrogant attitude toward fashion—that you can just order it, put it down, and people will buy it," says Eric Beder, a specialty retailing analyst at Brean Murray, Carret & Co.

CRASH COURSE

Wal-Mart did everything at once and precipitously, introducing ads even as it was flooding stores with new merchandise and before it could complete its store remodeling program. Bentonville was learning marketing on the fly and did not even attempt to adopt the sort of formal, centralized merchandise planning at which Target and many big department-store chains excel. Instead, Wal-Mart relied on dozens of individual buyers to make critical decisions as it pushed hard into unfamiliar product areas.

How else to explain why a retailer whose typical female customer is thought to be a size 14 loaded up on skinny-leg jeans? Or why Wal-Mart's cheap-chic Metro7 line got off to a flying start in 350 stores only to crash and burn as it was rolled out to 1,150 more? Or why Wal-Mart not only severely misread demand for George-brand basics but also is unable to replenish its stocks for months on end while "fast-fashion" chains such as H&M easily turn over entire collections every six weeks?

Scott loved Wal-Mart's bold new direction until he hated it, his enthusiasm diminishing in sync with same-store sales throughout much of 2006. "We are going to sell for less," Scott says now, emphasizing a return to Wal-Mart's first principles. "I believe that long after we are gone, the person who sells for less will do more business than the person who doesn't."

Yet Scott also signaled his continuing commitment to the pursuit of the middle-income shopper by promoting Fleming to yet another new post, chief merchandising officer, as part of a January shakeup of the senior ranks. Although Wal-Mart no doubt has sponsored its last glitzy runway show, Fleming insists that the company is sticking with its underlying strategy of "customer relevance"—that is, of moving beyond a monolithic focus on price to try to boost sales by targeting particular customers in new ways. "We're not going to back off," he vows. "We've learned certain lessons. Some things we'll build on, some things we won't."

While the look of its stores is primarily a function of how much Wal-Mart chooses to spend on them, the retailer is unlikely ever to come up with an ambience conducive to separating the affluent from their money without changing its whole approach to labor. The chain's dismal scores on customer satisfaction surveys imply that it is understaffing stores to the point where many of them struggle merely to meet the demands of its self-service format.

It is entirely possible even so that Wal-Mart in time will figure out how to sell vast quantities of dress-for-success blazers, 400-thread-count sheets, laptop computers, and even prepackaged sushi. But as Wal-Mart closes in on $400 billion in annual revenues, it is going to have to overachieve just to get same-store sales rising again at 3% to 5% a year.

The odds are that Scott, or his successor, will have to choose between continuing to disappoint Wall Street or milking the U.S. operation for profits better reinvested overseas. Only by hitting the business development equivalent of the lottery in countries like China, India, or Brazil can the world's largest retailer hope to restore the robust growth that once seemed like a birthright.

Click here to join a debate about Wal-Mart.

With Mara Der Hovanesian, Lauren Young, and Pallavi Gogoi in New York


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