The latest earnings report from Wal-Mart (WMT) suggests the company may have turned the corner with its long-term strategy of trying to keep up with Amazon’s (AMZN) dominance of e-commerce in the U.S. market.
With costs associated with improving its e-commerce results, it means the company may be moving toward a model closer to Amazon in regard to having to spend a lot to generate growth, at the expense of margins and earnings.
As a whole, Wal-Mart looks like it could generate some meaningful growth over the next year, and I think it could be a solid holding, even with some downward pressure on earnings. As investor response to Amazon has shown over the years, in the area of e-commerce, they’re more interested in revenue than earnings.
For that reason, I believe the market will reward the company with some upward momentum of its share price. The key will be that it continues to show it can generate revenue growth in this segment of the company.
For some time it appeared Wal-Mart wouldn’t even get the e-commerce side of its business down, as it floundered to get that segment of its business up to competitive levels that would at least give Amazon (AMZN) a significant domestic competitor.
For the second quarter in a row, Wal-Mart killed it with its e-commerce sales, soaring over 60 percent in the prior quarter, and by 50 percent for the quarter ended October 31. It appears much of this can be attributed to its acquisition of Jet.com last year.
At the same-store sales level, the retail giant was led by its grocery segment, growing at the fastest pace in almost six years. This will be important to watch over the next couple of years as Amazon works out and implements its strategy for Whole Foods.
It looks like to me that Wal-Mart’s growth will continue to be fueled by these two units of its company, rather than adding more stores – at least that’s how I view its strategy in the U.S. market.
For Amazon, it looks like it’ll continue to have to up its game to maintain its level of e-commerce market dominance. This is why it will work to make its Amazon Prime membership more compelling to its subscribers.
Latest earnings numbers
Here’s the latest key numbers from Wal-Mart’s last quarter. I want to focus on one of them because of the importance of it in relationship to its e-commerce business going forward.
President and CEO C. Douglas McMillon reported this:
The highlights for the quarter from my perspective are; the Walmart U.S. comp sales of 2.7% were strong; Walmart U.S. eCommerce sales were up 50%; adjusted EPS exceeded our guidance range; Sam’s Club comps were strong at 2.8%, and in International, 10 of 11 markets posted positive comp sales. So overall, we’re moving in the right direction. The productivity loop is starting to turn, and I’m encouraged by our results.
I want to focus primarily on earnings. Wal-Mart exceeded expectations on adjusted earning by 3 cents, coming in at $1 dollar per share. It also boosted its guidance for full-year adjusted earnings from a range of $4.30 to $4.40 per share to $4.38 to $4.46.
All of this appears solid, but consolidated earnings plunged to $1.7 billion in the quarter, a drop of 42 percent year-over-year. Diluted earnings per share were $0.58, down 41 percent in the third quarter.
Overall operating expenses remain high. Much of that is from its ongoing investment in its e-commerce business. As a result, free cash flow was down to about $10 billion, and operating cash flow to $17 billion, a combined decline of 18 percent year-over-year.
My point in focusing on earnings is Wal-Mart, in my view, is being forced to go the way of Amazon in regard to lower margins and earnings in order to grow e-commerce sales by increasing spending.
Where it could make up for some of that is with its cost savings relating to opening far fewer stores in the U.S., and its lowering employee count and costs with automated checkouts at its physical stores.
I have no doubt Wal-Mart will continue to grow revenue, but it’ll be at the cost of earnings. What remains to be seen is if the market rewards sales growth in a similar way it does Amazon.
The company said in the earnings report that it had its best quarter with its grocery business in about six years. It’s far too early in the game to suggest it has defended itself against competition from Whole Foods, as some investors may conclude from that.
Leading categories for grocery sales were “fresh meat, bakery, and produce.”
Wal-Mart has an online grocery presence in over 1,100 stores, and has plans to add another 1,000 in 2018. By online presence I mean they can pick up their online orders at the physical store and get a discount.
What makes it difficult to analyze in relationship to the potential impact Amazon may have on Wal-Mart’s grocery sales, is Amazon is mostly targeting the types of products that consumers have immediate knowledge of the prices on with discounts.
I’ve managed large retail stores in the past, and it was common knowledge in the industry that most consumers buy on price with approximately 30 items in specific retail categories, and if a company can beat competitors on those prices, it generates the impression of being a low-cost leader even if many other items sell at comparable prices.
This is what Amazon has been doing with Whole Foods. How much further it plans on extending the cuts on an ongoing basis beyond that remains to be seen. With the ability to use apps to quickly compare prices, which the customers in Whole Foods in particular would be more likely to do than a Wal-Mart customer, Amazon will need to lower costs on more items if it wants to take share away from Wal-Mart in particular in the grocery business.
It may take a little away on lower costs on a limited number of grocery items, but to really make a dent it’ll need to do better than that. It’s one of the reasons Whole Foods struggled with maintaining sales before Amazon acquired the company.
Also of interest, is while Whole Foods was cutting prices on the cost-sensitive items, it was increasing costs on other items not as much on consumers’ radar.
Amazon is going to cut costs during the holiday season, so we’ll see in the next earnings report whether or not that will have an impact on Wal-Mart’s sales.
In the short term I don’t think it will, but in the long term, depending on whether or not Amazon retains the costs cuts and at what level, it could change the game.
Where Amazon could have an edge is with its Prime members, who get an even further discount on Whole Foods products.
One other factor is there isn’t a lot of crossover with the customer bases of the companies, so how much organic sales will will migrate to Whole Foods and stay there has yet to be discovered.
After Whole Foods prices were initially cut after the acquisition, one study showed consumers did leave Wal-Mart and other competitors for Whole Foods, even though another study found overall prices at Whole Foods were only down 1 percent.
Wal-Mart has the best momentum it has had in years, and I think it’ll have a good last quarter.
The major element to look in for the long term is at what cost to earnings Wal-Mart will be able to compete with Amazon. Wal-Mart has to do it, as it has been considered for some time a mature business model that may have reached the beginning of the end of its perceived value to consumers.
It doesn’t have to win the e-commerce war in the U.S. to be successful, it only has to have a good showing and prove to customers it is committed to making it a good experience for them. If it can’t continue to do that, it will struggle to compete over the long term with Amazon, which has e-commerce down to a science.
On the other hand, Amazon must prove it can take Whole Foods and successfully turn it into the powerhouse it once was. It’s just beginning to take steps to do so. I see it taking a year or two to learn and adjust to a new retail environment before we can draw any conclusions to its potential.
Based upon some of the initial price cuts, it appears consumers are willing to give Whole Foods a try, but increased scrutiny will force the cuts to be permanent for many products, and ultimately, steeper. If they aren’t, Wal-Mart won’t be disrupted much by Amazon’s foray into the grocery business.
As Wal-Mart stated, it sees growth coming from e-commerce and same-store sales in the U.S. in the future, and that means expenditures in new stores will be minimal. That, and the growing number of automated checkouts, means it will cut costs in those areas in order to offset the increased spending for e-commerce and technology.
Even with the earnings beat, it does appear it faces some challenges over the long term to rein in costs associated with competing with Amazon.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
About this article:ExpandAuthor payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.Tagged: Investing Ideas, Long Ideas, Services, Discount, Variety StoresWant to share your opinion on this article? Add a comment.Disagree with this article? Submit your own.To report a factual error in this article, click here