Here's Why Wal-Mart's Stock Tumbled This Week
Business + Economy

Here's Why Wal-Mart's Stock Tumbled This Week

© Andrew Nelles / Reuters

"Now, when it comes to Wal-Mart, there's no two ways about it: I'm cheap," wrote Wal-Mart (WMT - Get Report) founder Sam Walton in his 1992 memoir "Sam Walton: Made in America."

If the notoriously cheap Walton were alive today, he would probably be surprised that his pioneering profit formula -- keep costs low so that prices are as low as possible and customers buy more -- is now virtually impossible to maintain. Full blame for that can be pinned on employees demanding higher wages and the rise of e-commerce giants such as Amazon (AMZN - Get Report) , which are open 24 hours a day, seven days a week. 

Related: How McDonald’s and Walmart Wage Hikes Can Boost the Economy

Perhaps the retail legend saw some of this on display from up above on what was a dark day in Wal-Mart's history on Wednesday. Wal-Mart's usually stable stock price tumbled 11% as the company said at its annual investor day that higher wages for associates will dent profits by about $1.5 billion in the 2017 fiscal year, following a $1.2 billion hit this fiscal year.

For years, Wal-Mart has had the upper hand with its employees, paying them state minimum wages, offering basic healthcare plans, and using computerized systems to control their hours. But with the rise of social media and the internet giving employees a free platform to express views, and the rising cost of living causing state governments to push through higher minimum wages, Wal-Mart has had to change with the times. 

As a result, it has lost a key element of its business model put in place by Walton that has supported the company's profits since its founding. Further, rising employee costs are arriving as online shopping is also limiting the ability of Wal-Mart to raise prices at all to help deliver sustainable profit growth.

Wal-Mart added on Wednesday that it expects earnings per share to decline between 6% and 12% next year. Wrote Sterne Agee analyst Charles Grom in a note to clients on Wednesday : "What's surprising to us is that the new outlook is incorporating roughly $20 billion in share buybacks in the next two years, which implies significant margin contraction along with modest sales growth." 

Related: Walmart Changes the Debate on Minimum Wage

Employee costs aren't the only line item on the income statement Wal-Mart is battling to control. 

Wal-Mart's investments in e-commerce and digital initiatives are expected to total about $1.1 billion in the 2017 fiscal year. This year, Wal-Mart is projected to shell out $1.2 billion to $1.5 billion on e-commerce and digital. 

These investments are a necessary evil to stay competitive with Amazon, as well as with Best Buy (BBY - Get Report) and Target (TGT - Get Report) , which are continuing down their own paths to reduce prices, improve checkout speeds and offer a range of delivery options.  

When Walton opened the first Wal-Mart store in Rogers, Arkansas in 1962, though, it's unlikely he foresaw a day when a sweater could be purchased off a handheld device. Today it can be, however, and to make it happen seamlessly and at the lowest cost is proving to be a major profit headwind for the once mighty Wal-Mart.

Related: Amazon’s Prime Concern—A New Online Blitz by Walmart

Even with such enormous investments in digital, however, Wal-Mart still sees sales as being under pressure. Wal-Mart said it now expects net sales growth for the current fiscal year to be relatively flat, down from a forecast of between 1% and 2% in February. Excluding the impact of currency exchange fluctuations -- mostly the stronger dollar -- net sales growth is estimated to be about 3%. 

"New guidance reflects that Wal-Mart's competitive edge -- historically largely assortment and price -- has faded relative to purveyors of extreme value (warehouse clubs, hard discounters) or extreme convenience (dollar stores, hard discounters), as e-commerce has neutralized the impact of selection," pointed out Goldman Sachs analyst Matthew Fassler in a note on Wednesday.  

The deterioration of Walton's pioneering business model has been playing out for some time in Wal-Mart's numbers. 

According to Bloomberg data, Wal-Mart's operating profit margins, which takes into account its costs to run stores and pay for wages and healthcare, has fallen from 7.1% in 1987 to 5.6% in 2015. From 1988, Wal-Mart's return on assets -- an indicator of how profitable a company is relative to its total assets -- has gone from 13.7% to 8.0% in 2015.

Related: Your Tax Dollars Pay for Walmart Execs’ Bonuses

The alarming downtrends in these measures, partly fueled by investments to compete online and compensate workers better, have been overlooked for years by Wal-Mart's investors who have focused on the retailer's healthy dividend and relative stability. 

But the stock's nosedive on Wednesday, and an 11% drop for the year prior to that point, suggests Walmart's investor base is growing concerned that the retail giant's business is broken. Wrote Stifel analyst David Schick in a note, "the market is reacting to meaningful evidence that Wal-Mart has substantially over-earned." In other words, Wal-Mart is now being forced to play catch up on investments it neglected to make in the past to keep the profits flowing. 

And if Wal-Mart's business model is broken, profits are likely to stay under pressure for some time, and future dividend hikes may not be as robust as in years past. 

Now, Wal-Mart has to find a way to channel Walton and become cheap once more. Indications have emerged that it may be willing to take drastic actions to return tosome sense of frugality

Related: U.S. retail sales edge up; producer prices hint at disinflation

"We are more than open to re-shaping our portfolio," said Wal-Mart CEO Doug McMillon at the investor event. McMillon added the company continues to "evaluate its portfolio" of assets, and pointed to Wal-Mart's history of exiting non-strategic assets and closing underperforming stores. 

For example, the retailer exited Germany in 2006 and took a $1 billion hit to profits as a result. By shedding assets such as Sam's Club or lagging international operations, Wal-Mart would also be shedding costs related to employees and maintaining physical stores. In turn, those savings could be used to offset the investments being made in core assets such as the online business and Wal-Mart U.S., or simply be brought to the bottom line to appease investors.

"You can make a lot of different mistakes and still recover if you run an efficient operation -- or you can be brilliant and still go out of business if you're too inefficient," wrote Walton. Words of wisdom from beyond the grave for McMillon and the execs tasked with turning around the largest ship in retail.

Wal-Mart did not respond to request for comment for this story.

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