How Wal-Mart Makes its Money

By Greg McFarlane | April 16, 2014 AAA

While convention dictates that it’s impossible to write about Wal-Mart Stores, Inc. (NYSE:WMT) without saying at least something critical or speculative about the company’s influence on social issues, the Bentonville, Ark., juggernaut remains the ultimate mom-and-pop success story. Wal-Mart was founded by a 44-year-old merchant who looked at the business model shared by the foremost retailers of the day – Woolworth, Sears – and found inefficiencies to exploit. Unlike the majority of chain store operators at the time, Sam Walton eschewed cities in favor of underserved small towns and later, the vast untapped suburbs. Wal-Mart’s first store opened in 1962 in Rogers, Ark., which had barely 6,000 people at the time.

Today, the superlatives flow freely: with 11,000 stores serving 245 million people weekly in 27 countries, it’s been decades since the sun set on the Wal-Mart empire. A workforce of 2.2 million employees, 1.3 million of those in the United States alone, means that Wal-Mart employs far more people than any other private company on Earth.

And Wal-Mart is getting bigger and bigger every year. The company estimates that it will add as much as 40 million square feet of retail space in fiscal year 2014. Or, if you prefer more illustrative ratios, about 180 square inches every second. This kudzu-like growth is the result of two initiatives so critical to the Wal-Mart way of doing business that they’ve achieved initialism status in the company’s literature. One of them is EDLP (Every Day Low Price), familiar to customers everywhere as the company’s slogan. The other, EDLC, is equally important to its profitability.

Wal-Mart's "Secret" To Success

Every Day Low Cost means using Wal-Mart’s size to reduce its per-unit expenses from suppliers. You don’t move $476 billion worth of merchandise annually without spending a lot (in Wal-Mart’s case, $358 billion). That figure is distributed throughout an ever-changing roster of suppliers (which number close to 60,000 by some estimates). As one industry source puts it, the result is “a unique situation where the world’s largest retailer has spawned a sub-industry of dependent companies.” These aren’t all small companies, either. Many of the S&P 500 components derive a significant chunk of their revenue from being Wal-Mart vendors.

As for EDLP, if it sounds to be so self-evident a strategy as to not need mentioning, it isn’t. Plenty of people will buy homogenous good X for price Y even when Wal-Mart is selling it for less. That’s because most retailers use what’s called the Hi-Lo strategy, which involves nothing more intricate than selling most products at a high price while temporarily lowering others to lure in shoppers. The steps in Hi-Lo retailing are simple: Set a higher-than-necessary price for most items, distribute a flyer offering a temporary reduction in price for others, have customers come in to buy the discounted stuff along with a few high-margin higher-priced items, profit. Less than Wal-Mart does, but still, profit.

EDLP isn’t exactly a closely guarded Wal-Mart trade secret, either. It’s all there, disclosed in the company’s annual reports and thus available to whichever competitors Wal-Mart hasn’t yet vanquished.

Every large business (indeed, even every successful small real estate investor) understands the concept of leverage: financing an investment with borrowed funds in the hope (or in Wal-Mart’s case, the near-certainty) that the profits will outstrip any interest. In that light, Wal-Mart also uses a particular accounting ratio to assess its performance. That’s operating ratio, which is just operating expenses divided by net sales. The theory goes that by measuring the former in terms of the latter, you’re also assessing the company’s imperviousness to increased supplier costs. As for Wal-Mart’s operating ratios, they’ve been remarkably consistent over the last few years. In reverse chronological order, they’re 19, 19, 19, 19, 20, 19, 19, 19…well, you get the idea. Compare that to competitors Belk (OTCQB:BLKIA), based in Charlotte, N.C., whose operating ratio was 25 last year, or Minneapolis-based Target Corp. (NYSE:TGT) at 22 last year, or Menomonee Falls, Wis.-based Kohl’s Corp. (NYSE:KSS), with an operating ratio of 23.

Treading Where Competitors Fear

Wal-Mart isn’t reluctant to buck convention, either. Take the practice of “showrooming.” If you’ve ever gone to a bookstore, had your fancy caught by something, typed it into your smartphone and then found it selling for less on Amazon.com, Inc. (Nasdaq:AMZN), you’ve showroomed. To some retailers (e.g. Circuit City Stores, Inc., Borders Group, Inc.), showrooming proved fatal. Wal-Mart, on the other hand, embraces it. Chief financial officer Charles Holley puts it in a refreshingly simple fashion devoid of corporatespeak:

“The era of price transparency is right here, right now and in real time. We welcome Wal-Mart being a showroom for online shoppers. […] If we offer the right assortment, the lowest prices and the best experience, customers choose Wal-Mart whenever and wherever they shop.” 

The United States might have the world’s largest and most dynamic economy, but there’s only so much profit a company can derive from a population of 318 million. Wal-Mart has never been afraid to turn its focus outside America’s borders, having opened its first foreign store in Mexico City in 1991. Not content to stop there, the company has since branched out into dozens of countries that less ambitious retailers have yet to touch, including Mozambique, Lesotho and Uganda. A generation after its first international opening, today fully 30% of Wal-Mart sales occur outside of the United States.

The Bottom Line

Size alone doesn’t make a company powerful or profitable- just ask anyone who invested in Fannie Mae or Freddie Mac. But size coupled with nimble management ready to continue growing is something quite different. It’s what has propelled Wal-Mart to historic growth, even in a very competitive industry.

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