Walmart: Where is the moat?

“The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” —Warren Buffett

In this post I will take a look at Walmart’s operating segments to see if there are any different characteristics between them. Do they all enjoy a moat, i.e., a sustainable competitive advantage, or not?

Let’s start with a brief business description taken taken from the 2014 annual report 10-K form. Underlinings and boldings made by me.

Business description

WMT2Wal-Mart Stores, Inc. (“Walmart,” the “Company” or “we”) helps people around the world save money and live better – anytime and anywhere – in retail stores, online, and through their mobile devices. We earn the trust of our customers every day by providing a broad assortment of quality merchandise and services at everyday low prices (“EDLP”), while fostering a culture that rewards and embraces mutual respect, integrity and diversity. EDLP is our pricing philosophy under which we price items at a low price every day so our customers trust that our prices will not change under frequent promotional activity.

Our operations comprise three reportable business segments: Walmart U.S., Walmart International and Sam’s Club. Our fiscal year ends on January 31 for our United States (“U.S.”) and Canadian operations. We consolidate all other operations generally using a one-month lag and on a calendar basis. Our discussion is as of and for the fiscal years ended January 31, 2014 (“fiscal 2014”), January 31, 2013 (“fiscal 2013”) and January 31, 2012 (“fiscal 2012”).

During fiscal 2014, we generated total revenues of $ 476 billion, which was primarily comprised of net sales of $473 billion.

Walmart U.S. is our largest segment and operates retail stores in various formats in all 50 states in the U.S., Washington D.C. and Puerto Rico, as well as its online retail operations, Walmart U.S. generated approximately 59% of our net sales in fiscal 2014 and, of our three segments, historically has had the highest gross profit as a percentage of net sales (“gross profit rate”), and contributed the greatest amount to the Company’s net sales and operating income.

Walmart International consists of the Company’s operations in 26 countries outside of the U.S. and its operations include numerous formats of retail stores, wholesale clubs, including Sam’s Clubs, restaurants, banks and various retail websites. Walmart International generated approximately 29% of our fiscal 2014 net sales. The overall gross profit rate for Walmart International is lower than that of Walmart U.S. because of the margin impact from its merchandise mix. Walmart International has generally been our most rapidly growing segment, growing primarily through new stores and acquisitions and, in recent years, has been growing its net sales and operating income at a faster rate than our other segments. However, for fiscal 2014, Walmart International sales growth slowed due to fluctuations in currency exchange rates, as well as no significant acquisitions, and operating income declined as a result of certain operating expenses.

Sam’s Club consists of warehouse membership clubs and operates in 48 states in the U.S. and in Puerto Rico, as well as its online operations, Sam’s Club accounted for approximately 12% of our fiscal 2014 net sales. Sam’s Club operates as a warehouse membership club with a lower gross profit rate and lower operating expenses as a percentage of net sales than our other segments.

We maintain our principal offices at 702 S.W. 8th Street, Bentonville, Arkansas 72716, USA.

Operating segment moat watch

The operating segments disclosure in the annual report provides some figures that could be used in trying to figure out the moatiness of each individual operating segment.

A great business generates high and sustainable returns on invested capital. The same holds true for any operating segment. For an operating segment to be considered great, it also has to be able to generate high and sustainable returns on invested capital.

Some of the metrics provided in the operating segments disclosure are net sales, operating income (or, Earnings Before Interest and Taxes — EBIT) and total assets. In the notes to the financial statements – Goodwill and Other Acquired Intangible Assets – goodwill per operating segment is disclosed. Having the goodwill figures at hand allow us to calculate tangible assets per operating segment (Total Assets minus Goodwill).

From this we can calculate return on invested capital (ROIC) per operating segment by taking EBIT divided by tangible assets, below called EBIT Return on Total Tangible Assets (EBIT ROIC).

Walmart as a whole generated an EBIT ROIC in fiscal year 2014 of 14.5%. Per operating segment Walmart U.S. generated the highest EBIT ROIC of 22.7%, compared to 8.2% for Walmart International and 14.4% for Sam’s Club.

What stands out is two things, 1) the superb returns generated by Walmart U.S. and 2) the not so good returns generated by Walmart International.

Clearly, Walmart U.S. seems to enjoy a moat which is consistent with earlier posts discussing the issue of likely competitive advantages enjoyed by Walmart. In the U.S. market Walmart seems to enjoy a moat through the benefits of captive customers via its Every Day Low Prices (EDLP) and economies of scale mostly in distribution, even if it seems reasonable to assume there also are some scale advantages from marketing and purchasing. Walmart International does not seem to have any of these advantages at the moment, at least not to the extent that it shows up in great returns as measured by the EBIT ROIC calculation. Upon reflection, this may not look as surprising as one might expect. Just as Walmart enjoys advantages in U.S., other retailers most likely enjoy, at least to some degree, the same advantages in their own domestic markets.

ROC1Below is a breakdown of EBIT ROIC and its two main drivers, EBIT margin (Operating income / Net sales) and Tangible assets turnover (Net sales / (Total Assets – Goodwill)).

  • EBIT ROIC = EBIT margin × Tangible assets turnover

In recent years, Walmart U.S. has shown a high and increasing EBIT margin. During the same period Walmart International’s EBIT margin has declined from 5.8% in 2006 to 4.0% in 2014. Sam’s Club’s EBIT margin has been pretty consistent during these years, close to 3.5%. At a consolidated level, Walmart’s EBIT margin has declined from 6.0% in 2006 to 5.6% in 2014, mainly due to the deterioration in Walmart International’s EBIT margin.


The second driver of EBIT ROIC, the tangible assets turnover shows that Sam’s Club enjoys the highest asset turnover. Asset turnover for Walmart U.S has been pretty consistent in recent years, hovering around 2.9 times. Walmart International has improved its asset turnover from 1.6 to 2.0, but due to the decline in EBIT margin the EBIT ROIC has not improved.


So, the Walmart operating segment moat king, at least as of today (and also in recent years) is Walmart U.S.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.


Measuring the Moat


Building a framework for measuring the moat

MTM2It is of utmost importance for an investor to know the concept of competitive advantages, what Warren Buffett refers to as a moat.  Another dimension that also is imporotant is the sustainability of any competitive advantages identified.

A great way to improve knowledge in this area is to read the report Measuring the Moat – Assessing the Magnitude and Sustainability of Value Creation written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse.

A few glimpses of the content of the report is found on the front page:

  • Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions.
  • This report develops a systematic framework to determine the size of a company’s moat.
  • We cover industry analysis, firm-specific analysis, and firm interaction.

Executive Summary

The first part of the report is a summary of the topics discussed in it. This section is included below.

  • Sustainable value creation has two dimensions—how much economic profit a company earns and how long it can earn excess returns. Both dimensions are of prime interest to investors and corporate executives. 
  • Sustainable value creation as the result solely of managerial skill is rare. Competitive forces drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation. 
  • Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. This report develops a systematic framework to determine the size of a company’s moat. 
  • Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return. 
  • Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance. However, industry effects are much smaller than firm-specific factors for low performers. For companies that are below average, strategies and resources explain 90 percent or more of their returns. 
  • The industry is the correct place to start an analysis of sustainable value creation. We recommend getting a lay of the land, which includes a grasp of the participants and how they interact, an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the five forces and a discussion of the disruptive innovation framework. 
  • A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external advantages. 
  • How firms interact plays an important role in shaping sustainable value creation. We consider interaction through game theory as well as co-evolution. 
  • Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service. 
  • We provide a complete checklist of questions to guide the strategic analysis in Appendix A. 


Walmart: Competitive Advantage & Its Nature (Part 1)

Background: A framework of competitive advantages and some thoughts about Wal-Mart in 1974

This post is about Wal-Mart in the beginning of the 1970’s. The second part will look at Wal-Mart as of today.

Yesterday I read a post over at CSInvesting about analyzing Wal-Mart to try figuring out its competitive advantage and its nature.

Let’s get back to Wal-Mart. What is the essence–the key–to its ability to grow profitably for so long? What can you spot in the 1974 annual report that would have CSInvesting

First, I just read through it once. Then in the evening I had some time at hand so I picked up Wal-Mart’s annual report for fiscal year 1974 and then the annual report from 2012. WMT1

So, with this post I thought I would make an attempt to touch upon the question about any likely competitive advantages enjoyed by Wal-Mart in 1974 and its nature.

Business analysis is all about getting to know the fundamentals of a business as good as possible. Well, how then can one know if there is a competitive advantage present or not when looking at a business one might ask? I think the best answer to that question is that you have to know in some way what you’re looking for. You need a theoretical framework that contains different likely competitive advantages that a business may enjoy.

From there on, it’s all about reading about businesses, and then read some more. Reading is key. Focused reading is key. Pick a business or an industry, one at a time, and don’t move on until you feel that you know the fundamentals of the business or decide it’s too hard to figure out. Adopt the Charlie Munger approach “In,” “Out” and “Too hard.” 

You have to go out and find the great companies, they will not come to you. Applying the theoretical framework containing the different competitive advantages helps you figure out if a specific business seems to enjoy any of the advantages. This will take time, but it will be great time spent because you will learn a lot. You will accumulate knowledge that you can use further on when looking at other businesses.

The key to investing intelligently is doing a thorough business analysis and to know what makes one business better than another. At the same time you have to keep your own feelings in check. As Richard P. Feynman once said The first principle is that you must not fool yourself and you are the easiest person to fool.”

To start with, I want to make clear that I read Competition Demystified a few years back. I don’t know the exact words that it said about Wal-Mart, but I can say that the book analyzed Wal-Mart’s competitive position and I remember that the analysis was great. But, I won’t stay away from having another look just because I have already read the book. I just want to tell everyone that this book from Greenwald is definitely on my list of the best books to read to learn thinking about competitive advantages and strategy. It has influenced me a lot. So if my analysis is close to Greenwald’s, it’s because I read his book and learned a few things. If my analysis turns out not to be, I better go back and read Competition Demystified once again, because it is a great book that every business analyst and investor should read.

So, with this said. I think it’s time to take on Wal-Mart in 1974.

Wal-Mart’s annual report from 1974 

Some notes from my reading of the 1974 annual report follows here:

  • High and consistent growth in both revenues and earnings in 1970-74
  • Revenues of $169.4 million (126.5 in 1973) and earnings of $6.2 million (4.6 in 1973)
  • Number of stores at year-end was 78 (64 in 1973)
  • Store locations concentrated to Arkansas, Missouri, Oklahoma (see map below) with distribution center right in the middle in Bentonville, the same place where its general office is located.
  • “New stores scheduled during fiscal year 1975 will be within the 350 mile radius served by our Distribution Center.”
  • “A new 150,000 square foot addition to our present distribution system is projected for this year, hopefully to be completed by September 1974. At that time, our total Distribution Center and General Office space will exceed 400,000 square feel.”
  • See tables below for some financial data from the P&L, Balance sheet plus some financial ratios (click them to see better… I know it’s unreadable if you don’t)
  • High returns on invested capital
  • High and stable gross and operating margins

Here are some tables from the annual report that gives the reader a hint about the rapid and consistent growth in the years leading up to 1974.


From looking at the P&L the consistent growth coupled with high returns on invested capitals gives a hint that Wal-Mart seems to be doing something right. Three year average gross and operating margin were 26.4% and 7.7%.


A look at the balance sheet shows high growth in shareholders equity together with growing assets and debt. Growing at this high a growth rate requires capital. Even though the debt increased a lot, the whole business grew as seen by higher revenues converted to profits and also from looking at different lines in the balance sheet compared to net sales.


Return on equity was high, 20% in 1974 compared to a three year average of 22%. Return on invested capital (ROIC) was 31% in the same year, compared to a three-year average of 34%. Financial leverage was around 2 times and debt to equity was 0.36 and equity to total assets was 0.51 in 1974.


Likely competitive advantages and its nature

If I had to pick one picture to show from the 1974 annual report, it would be the map on page 8-9 showing all the store locations that are concentrated around the distribution center. Wal-Mart started off from Bentonville, from where it expanded its store locations and business operations. This concentration likely resulted in economies of scale in distribution and also in marketing.


Local concentration of store location – a powerful force in creating high returns

I have put together a list of the different kinds of competitive advantages a business may enjoy. From looking at Wal-Mart and going through the list (see table below), it seems reasonable to say Wal-Mart did not enjoy any cost advantages (i.e. superior production technology or privileged access to crucial inputs) above keeping costs low from operational efficiency. The same seems true for any government interventions.

So, from this, we go on to look if there seems to be any advantages from demand or economies of scale.

By looking at the map we see that stores are located close to each other in a cluster. This should give an advantage in distribution, advertising, and also in managing the stores, that a competitor with only a few stores in the same area wouldn’t be able to enjoy, at least not in the same extent. Wal-Mart’s focus on everyday low prices would probably also attract customers and hopefully keeping them from shopping elsewhere, so some habit formation here.

If we look at the different kinds of customer captivity, search costs are probably pretty low if not nonexistent. One has to assume that pretty much everyone could find out price levels in competing stores without investing too much time and effort. There might be some switching costs, in the sense that customers have to pay higher prices if they decide to go shopping at a competitor’s place.

When buying groceries most customers reasonably want two things, low prices and good (if not great) quality.

Groceries are bought periodically and it becomes a bit of a habit of going to the same store or chain. So, some customer captivity from habit seems reasonable to assume there is. But in the end a lot of people are willing to change stores to get even lower prices. So, as long as prices are low enough compared to competitors customers probably stay.

The most important thing in the grocery business is keeping prices low, to enjoy some customer captivity from habit and some switching costs. This becomes a feedback loop, with lower prices attracting more customers and more customers making it possible to keep prices at a low enough level.

Enjoying economies and scale, local in the case of Wal-Mart, and at the same time being able to attract a lot of customers means a business can spread its fixed costs (marketing, depreciation, distribution, management and other overhead expenses) over a greater revenue base, i.e. higher margins and returns on capital. This effect is also enhanced by the fact that stores are located in a limited area around the distribution center. Also, Wal-Mart looks to be operationally efficient in the way it conducts its everyday business, also a positive, even though it’s not considered a true competitive advantage.


To wrap this up, Wal-Mart in 1974 seems to enjoy competitive advantages from some customer captivity and local economies of scale (remember the map). If Wal-Mart where to expand into other areas these advantages would most likely be enjoyed by incumbent in these markets.

Having found a business enjoying a competitive advantage, the next question is about the sustainability of it. To say something about it, I am not really sure how one is supposed to proceed in trying to conquer Wal-Mart in this local area. So at least in the beginning of the 1970’s it should have been reasonable to expect Wal-Mart to keep its competitive advantages for some time in this local area where it operated, and by doing so protecting its profits from any potential entrants.

For a more thorough analysis of Wal-Mart’s competitive position in 1974 and its development from there, see Competition Demystified by Bruce Greenwald.