Walmart, Inflation, and Ads
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“We’re a people led, tech-powered omnichannel retailer that’s dedicated to helping people save money and live a better life.” - Doug McMillon, Q42023 earnings call
Walmart’s past four quarters are a good proxy for the health of the overall economy, which is to say that no one has any idea what the health of the economy currently is. The company’s initial guidance for the year was for net sales and operating income to both grow by 3%. Management then cut operating income guidance after Q1, cut it again halfway through Q2, raised it after Q2, and then raised it again after Q3. It ended the year with net sales up 6.7% and adjusted operating income down 5.2% in constant currency.1 Predictably, inflation drove both the net sales beat and the adjusted operating income miss. While Walmart taken as a whole is a good representation of the macro environment, a more detailed picture gets much more interesting, and that detail will be the focus of this week’s piece.
A Natural Hedge
“One of the things I’ve always appreciated about this company is that it’s naturally hedged. If customers want more of something and less of something else, we shift our inventory. If the economy is strong, our customers have more money….If things are tougher, they come to us for value. With today’s inflation, we’re continuing to see that happen.” - Doug McMillon, Q42023 earnings call
It’s better to be Walmart than an apparel or discount grocery business. When the economy is booming apparel businesses thrive, but discount grocers have no ability to capitalize on that, and sales are hurt because customers care less about low prices. When the economy is doing poorly apparel businesses struggle, and have no ability to rely on a discount grocery business to drive compensatory demand. Walmart is fortunate to operate in both of these segments, among others, and in this sense is naturally hedged. During Covid general merchandize sales thrived, particularly as people shifted spending to goods rather than experiences.2 2023 saw general merchandize growth turn negative, but strong grocery and health/wellness growth made up for that decrease, at least from a net sales perspective. That clarification is important. While Walmart’s net sales didn’t suffer this year, profit margins and operating income did. A strong economy doesn’t just mean that customers have more money, but that customers have more money to spend on items that are higher margin. It’s useful to have multiple business lines that behave differently in different economic periods, but unfortunately general merchandise and grocery don’t share the same margin profile, creating compression in tougher times.3 This compression is worse when consumer demand weakens suddenly, as it did in the first half of 2023. The sudden change led to general merchandize markdowns, and so not only lower general merchandize sales but also lower general merchandise margins. Walmart was exceptionally unlucky during this period, as this change in consumer demand was combined with higher than expected wage, fuel, and supply chain expenses, driving a sharp increase in OpEx.4 It’s unlikely that these factors will coalesce perfectly again even if the economy does continue to weaken, but it is worth noting that Walmart has a naturally hedged business in some respects, but perhaps not in others.
Higher Income Customers
“We've continued to gain grocery market share from households across income demographics, with nearly three-quarters of the share gain coming from those exceeding $100,000 in annual income.” - Josh David Rainey, Q32023 earnings call
One promising segment of Walmart’s business over the past year has been the strong growth in higher income families as customers. This is important for two reasons:
Walmart is gaining a new customer segment even during an economic downturn.
This new customer segment has a lot of disposal income, which Walmart could capture over time.
Point (2) is critical. A non-ideal scenario for the company would be these high income customers stay with Walmart only during the period of economic duress, then resume their old shopping habits once the economy improves. Management understands this, as seen during a recent investor Q&A:
“Investing in price doesn’t necessarily translate to loyalty. There are other things that could translate to loyalty longer term, even when we’re not in this inflationary period. We’d like to have more Walmart+ members. We’d like to have more customers shop both stores and eCommerce. When somebody shops both, as we’ve told you before, our share of wallet goes up, and they stick with us in a bigger way for a longer period of time.” - Doug McMillon, 2022 Investment Community Q&A
This is a different message from “Save Money. Live Better.” Walmart’s brand is about everyday low prices, which is a key selling point for much of its customer base. It’s also why higher income customers are coming to Walmart during this period of inflation, but it may not be a good enough reason to get them to stay once inflation dies down. This outcome wouldn’t be a terrible one. It still helps the company in tough economic periods, but it’s a lost opportunity in more prosperous ones. Given that price matters less to higher-income customers, Walmart has to turn to other initiatives to create customer habituation, which is why both Walmart+ and omni-channel matter. That’s also part of why it’s important that Walmart+ has lower free grocery delivery minimums than Amazon Prime: the more product-usage friction you can remove in times when price does matter, the more frequently customers will use it now, and the more likely it is that they’ll continue usage even once the economy picks up.
Looking Ahead:
“We'll keep shaping the business model by scaling our newer, mutually reinforcing businesses in areas like Marketplace, Fulfillment Services and advertising.” - Doug McMillon, Q42023 Earnings Call
“I can’t remember a business with the margin structure of the advertising business here at Walmart.” - Doug McMillon, Q22023 Earnings Call
Walmart’s been a retailer since the beginning of its existence, which is another way of saying that it’s never had high margins. Its ad business has the potential to change that, and has shown impressive growth thus far, growing nearly 30% in the past fiscal year. This gets more exciting when one realizes that the business is three years old and currently does 2.7B in revenue as compared to Amazon’s 37.7B, leaving significant room for expansion. The larger Walmart’s third party marketplace, the larger the advertising opportunity, which makes growing that marketplace essential. This is why the fulfillment services business matters. It’s higher margin than retail, but much more importantly it’s a compelling reason for merchants to join the Walmart Marketplace and creates a better experience for customers through increased delivery reliability.5 This makes customers more likely to come back to Walmart.com, so the site gets more eyeballs, merchants get more sales, prospective merchants are more likely to sign up, and the advertising opportunity gets larger. A successful advertising business would enable Walmart to grow profits faster than revenue, and also means the overall business deserves a higher valuation multiple.6 An additional benefit, which management hasn’t discussed for obvious reasons, is that ads could subsidize its retail business, letting Walmart lower its prices to levels that are economically impossible for pure retailers to match. This enables two things: taking more market share from traditional competitors and competing more effectively with Amazon. So the advertising business gives Walmart a trifecta: higher margins, greater retail market share, and a higher multiple to top it all off.
The company differentiates between net sales and revenue, as revenue includes Sam’s Club and Walmart+ membership fees.
General merchandise is anything that doesn’t fit into grocery or health/wellness categories, whether that be toys, electronics, apparel, or otherwise.
This is why having a private brands business matters. Private brands items are cheaper than brand-name equivalents and are also higher-margin for the retailer, creating a particularly wonderful countercyclical income stream. Predictably, Walmart’s private brand sales have increased over the past year.
See the Q1 earnings call for more info.
Bezos described the benefits of handling fulfillment for sellers well in his 2013 Letter to Shareholders: “It’s not often you get to delight two customer sets with one program. With FBA, sellers can store their products in our fulfillment centers, and we pick, pack, ship, and provide customer service for these products. Sellers benefit from one of the most advanced fulfillment networks in the world, easily scaling their businesses to reach millions of customers. And not just any customers – Prime members. FBA products can be eligible for Prime free two-day shipping. Customers benefit from this additional selection – they get even more value out of their Prime membership. And, unsurprisingly, sellers see increased sales when they join FBA.”
It’s hard to command a high multiple as a pure retailer, but a high margin advertising business helps Walmart’s case significantly. Recurring revenue from Walmart+ and Sam’s Club also doesn’t hurt.