Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Please use this as a supplement to your reading of Chapter 5: Big Where IT Counts: Wal-Mart, Coors and Local Economies of Scale. Pages 77 to 112 in Competition Demystified by Bruce Greenwald. See: http://www.scribd.com/doc/78527294/Wmt-50-Year-Chart. Go to Value Vault for Harvard Case Study: Wal-Mart Stores’ Discount Operations 9-387-018. Mentioned here http://wp.me/p1PgpH-gO You must understand economies of scale and the lessons of Wal-Mart’s success to improve as an investor. Later we will study Coors. Analyzing Wal-mart: Case Study #1 Strategy involves external interactions while operations and organizational behavior has to do managing within the firm. There is no single solution to these problems (case studies) so we will use a staged approach to analyzing the problem. One version: make a sequence of simplifying assumptions. Remember Hannibal Lecter’s suggestion to Clarissa, “Simplify. Ask, “What is its nature?” There are no direct conscious interactions among participants. The firms just blindly pursue the available profit opportunities. That army of ants’ behavior leads to industry analysis and the important concept, which are competitive advantages. Remember that without incumbent advantages there are no B-t-Es and there won’t be an identifiable cast of characters. Incumbent Competitive Advantages (CAs) and Barriers to Entry (B-t-E) and franchises all amount to the same things. These CAs do not come in a large number of forms. They come in the form of consumer demand side advantages such as customer captivity. There is something that you can do that others can’t match. The alternative is to have a lower cost structure than your competitors. Proprietary Technology—importantly reinforced by EOS. Competitors can’t acquire that scale of operations. Those are the three things you want to focus on. Sometimes the government is your friend, sometimes in financial services there is captive information. We talked last time about the cookbook approach to doing this analysis. Look at all sides. Start with an Industry Map, then go segment by segment and ask, “Do competitive advantages exist?” (Hint: A valuable way to study an industry is to do an industry map, plus the research can be an entre for a hedge fund job for those so inclined. The initial work is tough, but you can update the industry map through your career as an investor). What indicators to look at? First look at profitability (ROA, ROE, ROIC) and then market share stability--stability in the leading firms, stability in the roster of firms, and in market share. ROIC and use ROE only with financial firms (usually distorted by leverage) to analyze market share stability. Once you verify if there are CAs-if not, then it is just a matter of organizational effectiveness, so where are the CAs here. Are they consumer or producer CAs and/or are they reinforced by
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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

EOS? The entrants can’t acquire the same customer captivity or special resources that you, the incumbent can. Once you have identified the force, nature and location of CA or not CA, you are ready to think about strategy. Case Study of Wal-Mart Discount Stores’ Operations DESCRIBE WHY YOU THINK WAL-MART HAS BEEN SO SUCCESSFUL? In 40 years, Wal-Mart (WMT) rolled out of small towns (population less than 50,000) in Arkansas to become the largest retailer in the world; one of the greatest successes in business history. It is also the most compelling example of how a strategy built on a local focus can produce a company that dominates both its original market and neighboring ones into which it expands. Sam Walton had the insight that rural America could support the same kind of full-line, lowpriced stores that had become popular in larger cities. He found a smaller niche ignored by the big discounter like K-Mart. Mr. Walton gave the consumer in smaller towns lower prices and greater choice of goods while keeping his costs lower than competitors. 1970 30 36 million in 1971 End 1985 859 $230 billion in 2001*

Stores Market Cap *FY end Jan. 31.

WMT was more profitable and more reliable in its profitable growth than Sear, Kmart, and JCPenny year in and year out over 40 years. When a company has been this successful in this kind of competitive environment, with no patents, government licenses, or years of productive research and development to keep wouldbe contenders at bay, any student of business strategy wants to identify the sources of its success. 1. Has WMT’s record been a triumph or have there been blemishes that may have been overlooked? What roadblocks may WMT face in the future? 2. What did WMT do that other retailers were unable to duplicate, and we may be able to identify strategic choices that WMT might pursue to maintain and extend its superior performance. 3. What does WMT’s success says about the possibilities facing other companies. Competitive Advantage on Demand Side—Customer captivity. Capture customers through location and price? Cost side more efficient. Decentralized orders but centralized buying. Local stores have autonomy.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

In the customer’s mind: Wal-Mart is the king on low prices—“Everyday low prices.” How would customer captivity (“CC”) show up to underlie WMT? In being able to raise prices? WMT can’t raise prices, so little customer captivity. Who is WMT’s competition? Kmart. Kmart’s Prices= X WMT = X-1.3% lower prices. WMT doesn’t have much customer captivity (CC). Definition: The essence of CC: Your demand from customers at the same price is better than your competitors--would you order Coke at 60 cents a bottle or Glotz’s Cola at 60 cents? Wal-Mart in Dallas and Fort Worth has prices 9% less than Kmart. WMT has 2% to 3% lower prices on average than competitors. Does it have demand side CC? WMT is very efficient. How does WMT profitability compare to the Industry’s profitability? Industry WMT Difference

COGS EBIT Better Profitability Shrinkage Inbound logistics Purchase Costs

71.9% 5.9% 2% 4%

73.8% 8.7% 1.3% 2.8%

-1.9% 2.8% 2.8% 0.7% 1.2%

Could their difference in Cost of Goods Sold (“COGS”) be from different product mix between more hard goods (high COGS) than soft goods? 4/10ths of 1% higher costs for COGS due to greater mix of hard/soft goods. Does WMT have purchasing power advantages if it is buying 95% of its products from branded product producers? No. Who gets hurt if WMT doesn’t carry Crest Toothpaste? WMT or P&G? WMT. Branded goods pull customers. WMT has little bargaining power when purchasing from national brand producers like Colgate or P&G. Cost differences didn’t reside in COGS. If WMT receives the same prices from suppliers (little bargaining power and purchasing power) then COGS higher. Despite the growth of sales and company locations, COGS as a percent of sales has stayed the same. Theory of Competitive Advantage—look carefully from different perspectives. WMT’s profits did not increase as it got bigger. Note financial on the last page of this case study.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Could COGS be hiding something? Purchased prices + inbound logistics (storage) + Shrinkage? Kmart was original 3xs bigger than Wal-Mart in 1975. It should have purchasing power advantages over Wal-Mart. WMT has 3% lower prices than the average while others have 3% prices over the industry average. A difference of 5% to 6%. Always verify your argument against the numbers & facts. WMT gets 60 days to pay vs. 30 days for competitors. If interest rates are 7.2%, so 1/12 of 7.2% is 6/10th of 1%. Purchasing power: remember big is defined by relative size. State Arkansas Missouri Oklahoma Tennessee 1985 WMT Stores 71 90 71 67 1985 Pct. of Tot. Disc. Stores 45% 40% 36% 30%

The trend in advertising for WMT. They are using more TV advertising. WMT sales: $1.2 billion in 1979 and $8.4B in 1985. $3.7 million in advertising. Only 0.02% of sales. TV advertising as a percentage of sales is declining—so economies of scale at work. Consumer behavior with discount stores: focus on price, less loyalty and customer captivity. Note change in players over the years. Sears, Woolworth, then JC Penny, then Kmart and now WMT. Target has a focus on more upscale stores-more variety, nicer stores. WMT-Payroll is 1.1% better, shrinkage 0.7% better. WMT gets more out of its employees? 2% better than competition? Is IT (technology) a competitive advantage? NO. Technology provided by third parties and available to others. Not proprietary. If it is efficiency of culture, then there can be an erosion of margins over time. Geographic Concentration? WMT expanded at the margins of their geographic concentration. Fixed costs for distribution, advertising and mid-level management is lower for their level of sales. WMT reinforces customer captivity by advertising everyday low prices. They can do more intensive advertising per dollar of sales in a local area. As WMT moves out of its geographic concentration, its profit will fall. WMT has local (regional-Missouri, Arkansas, Oklahoma, and Tennessee) economies of scale or regional economies of scale (“REOS”). WMT is very geographically concentrated in the south central U.S. Save on overhead costs—the entire middle management layer is based out of Bentonville, Ark. Large warehouse costs. More units sold per unit of distribution costs. Much bigger advantage in distribution costs. 30% cost difference than other discount stores.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

Advertising advantages: More sales per advertising dollar. Relative advertising expense is 70% better than competitors. WMT does not need a layer of regional managers. All based out of Bentonville. Thus, a big savings in fixed cost supervision—two percent in overhead.

Wal-Mart Difference: The geographic concentration allows WMT to get lower distribution costs, lower supervisory costs, and lower advertising costs.
Geographic regional concentration (Central SW) is the source of their CA. Expansion at the margins of those regions. If the source is single store markets: Their expansion has to be small towns. After they go into small towns, then no more growth except for nominal price increases of prices. A lot of fixed costs for advertising and overhead and distribution. Geographic concentration more efficiently uses their fixed costs. Advertising helps develop some form of customer captivity. Sam’s Club is not profitable. It lacks geographic concentration? Rent-more discounts due to geographic concentration. Most profitable store on RIOC: Wal-Mart. Then Target. Dayton Hudson has a geographic concentration in NW. Kmart started out with geographic concentration in the upper mid-west (HQ in Detroit just like WMT in Arkansas). What happened to their profitability when they went national? It went down. When you look at the Bradley’s of this world, you see their low profitability. You see this pattern with retailers. Without geographic concentration, they are at a competitive disadvantage. An army of ants. WMT was good at geographic concentration in 1986. Who is more profitable between Wal-Mart and Target (2005)? It is now Target. Who is in the process of undoing that? Target! Almost all services are characterized by regional economies of scale—concentrate on regional economies of scale. Local and geographic domination is critical. The fundamental competitive advantage is regional and in some cases local EOS reinforced by a small degree of customer captivity.

Next to the WMT type of geographic concentration, serial concentration is the next best thing.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

FACTS: WMT had centralized purchasing. Used in-store sales forecasts. Stores were closely packed together in a geographic area so distribution was more efficient. One truck could resupply two or three stores on a single trip. Trucking back hauls had 60% occupancy—better than industry averages. Rapid store expansion was the reason new distribution. Centers were needed to contain delivery times and transportation costs and to cope with regional differences in consumer preferences. Each center meant to serve up to 175 stores within a 150 to 300 mile radius. Inbound logistics costs were 2% for Wal-Mart—about 1/3 those of the industry (6% of sales). Building rentals accounted for 1.8% of sales in the late 1970s—the lowest rate for any discounter. Inventory turns averaged 4.5x—more than other discounters. WMT averaged 0.2% licensee fees as a percentage of sales. Vs. 0.4% of sales for the industry. Branded merchandise made up 95% of its sales. Shrinkage was embedded in the COGS. WMT has shrinkage 1.3% vs. 2% for the industry as a whole due to better employee incentives and culture. Lessons from Wal-Mart’s most profitable period Efficiency always matters. Good management kept payroll costs and shrinkage substantially below the industry averages. Competitive advantages, in this case local economies of scale couple withy customer captivity, matter more. Good management could not make Sam’s Clubs a runaway success, nor could it prevent the deterioration of Wal-Mart’s profitability after 1985, nor assure success in international markets. Competitive advantages can enhance good management. In this case, Wal-Mart utilized its advantage of local economies of scale by passing on a portion of its savings to its customers and by running a very tight ship. It made efficient use of management’s time, their scarcest of all company resources. Good management was welded to a good strategy. Competitive advantages need to be defended. Wal-Mart’s low-price approach was an intrinsic part of the local economies of scale strategy, and not a separate policy choice. Other discounters like Kmart, Caldor, and Korvette all had profitable periods during which they took advantage of their local economies of scale. But in their drive to expand beyond their home turf, itself an ill-chosen strategy, they let competitors move uncontested into their local areas and lost on two fronts.

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Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

The significance of the Wal-Mart’s example is due to more than its size and prominence. What appears to have been true for WMT—that the crucial competitive advantage lies in local economies of scale—applies to retail industries in general. Supermarket profitability tracks closely with local market share. The importance of geographic concentration applies beyond pure retail into services, at least to the extent that they are locally supplied. Review of Economies of Scale If a company expands its scale of operations, what happens to unit costs? If these unit costs fall, the organization is experiencing economies of scale. Imagine a cost curve in which unit costs decline for a period and then level off at Q*. This L-shaped curve is relatively common. The output level Q* is known as the minimum efficient scale of production (or the MES) for the industry, and plays an important role in determining entry patterns: The minimum efficient scale of production (MES) is the smallest volume for which the unit costs reach a minimum. In other words, the smallest output level at which economies of scale are exhausted is Q* (the lowest point on a cost curve). Definition of Economies of Scale The production for a specific good or service exhibits economies of scale over range of output when average cost (i.e., cost per unit of output) declines over that range. For average cost (AC) to decline as output increases, the marginal cost (MC, i.e., the cost of the last unit produced) must be less than the overall average cost.1 If average cost (AVC) is increasing, then marginal cost must exceed average cost, and we say that production exhibits diseconomies of scale. One needs also to know the ratio of minimum efficient scale to the overall size of the market. This ratio tells us the market share required for a low-cost entry into a market. All else being equal, the larger the MES is relative to the market, the greater the expected wedge between pre-and post-entry price, and thus the less likely entry is to occur. Further Analysis of Case Was Wal-Mart stock a good buy at a price-earnings multiple of 26 in 1986? How would you go about determining that? What risks or problems will management face as the company grows?

1

Suppose that the total cost of producing five bikes is $500. The AVC is therefore $100 or $500/five bikes. If the MC of the sixth bike is $70, then total cost for six bikes is $570 and AC is $95. If the MC of the sixth bike is $130, then total cost is $630 and AC is $105. In this example when MC is less than AVC, AVC falls as production increases, and when MC is > AVC, AVC rises as production rises. Obtain a good microeconomics textbook like Economics of Strategy by D. Besanko to study economies of scale. www.csinvesting.wordpress.com Studying/Teaching/Investing Page 7

Wal-Mart Stores’ Discount Operations 1986 Case Study Analysis

WMT Net Sales Lic. Fees & Other Inc. Totals Sales Growth

1976 479 5 484

1977 678 8 686 41.7%

1978 900 10 910 32.7%

1979 1248 10 1258 38.2%

1980 1643 12 1655 31.6%

1981 2445 18 2463 48.8%

1982 3376 22 3398 38.0%

1983 4667 36 4703 38.4%

1984 6401 52 6453 37.2%

1985 8451 55 8506 31.8%

COGS COGS Pct. Of Sales Gross Profit

353 72.9% 131

504 73.5% 182

661 72.6% 249

919 73.1% 339

1208 73.0% 447

1787 72.6% 676

2458 72.3% 940

3418 72.7% 1285

4722 73.2% 1731

6361 74.8% 2145

Operating SG&A exps.

95

135

182

252

332

495

677

893

1181

1485 17.5%

Pct. Of sales 19.6% 19.7% 20.0% 20.0% 20.1% 20.1% 19.9% 19.0% 18.3% Note that COGS does not decline but SG&A as a percentage of sales does as sales increase. Fixed Cost Advantage not Var. Costs. EBIT EBIT as Pct. Of Sales Interest Cost Taxes 36 7.4% 5 15 47 6.9% 7 20 67 7.4% 10 27 87 6.9% 13 33 115 6.9% 17 44 181 7.3% 31 66 263 7.7% 39 100 392 8.3% 35 161 550 8.5% 48 231

660 7.8% 57 276

Net Income Net Income growth Net Income as Pct. Of Revs. Capital LT Debt + Cap. Leases Share Equity ROE Pre-tax ROIC

16

20 25.0%

30 50.0% 3.3%

41 36.7% 3.3%

54 31.7% 3.3%

84 55.6% 3.4%

124 47.6% 3.6%

196 58.1% 4.2%

271 38.3% 4.2%

327 20.7% 3.8%

3.3%

2.9%

60 64 25.0% 29.0%

80 96 20.8% 26.7%

98 127 23.6% 29.8%

122 165 24.8% 30.3%

165 248 21.8% 27.8%

259 324 25.9% 31.0%

329 488 25.4% 32.2%

381 738 26.6% 35.0%

491 985 27.5% 37.3%

776 1278 25.6 % 32.1 %

At 26 times price to earnings in 1986, is WMT a buy? How would you go about answering this question? What issues might the company face?

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