First in a Two-Part Series

How Walmart's Vaunted 'Loop' Turned Into a Vicious Circle

As New Store Openings Slow, It Has Become Harder to Boast Lowest Prices and Also Deliver Fattest Margins

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The business model developed by Sam Walton in the 1960s to attract shoppers used low costs to lower prices. The more shoppers, the more efficient Walmart got, letting it lower prices further and attract even more shoppers. This is the famous "productivity loop," and it's pretty simple.

But it's increasingly hard to pull off in the U.S., where Walmart's namesake chain delivered its ninth consecutive quarter of declining same-store sales last quarter. Its prices have been rising relative to competition, as CEO Mike Duke acknowledged last week.

So what happens when a brand built on low prices doesn't have such low prices anymore? People notice. That's caused some to buy less, particularly in a bad economy. So the productivity loop has morphed into a vicious circle.

Despite Walmart's rededication last year to its everyday-low-price philosophy and recent ads focusing on its "ad-match guarantee" against more promotional competitors, Morgan Stanley last month reported that 60% of Walmart shoppers don't believe the retailer actually has the lowest prices anymore. Another survey released earlier this month by WSL Strategic Retail found an even broader 86% of shoppers no longer believe Walmart has the lowest prices -- though that was fielded in April, just as Walmart's latest EDLP-focused ads began.

Price comparisons by Kantar Retail of Walmart and Target in recent years have shown pricing across a 40-item shopping basket generally close, with Target winning about half the time. The most recent survey released last week found Walmart had a 1.2% edge, but that was more than wiped out among Target shoppers getting the 5% discount from using its RedCard. Morgan Stanley also found Walmart's price gap vs. supermarkets has narrowed five to 10 percentage points since 2008. Though Walmart prices are still 15% to 20% better, that puts more retailers in a position to use loyalty programs to keep their most profitable customers from straying.

So why has Walmart let its pricing edge erode?

A secret ingredient in the productivity loop was rapid store growth in prior decades, which boosted sales and efficiency so much that prices could stay lower. But Walmart has slowed expansion as existing markets got saturated and big urban coastal markets resisted stores. Last year, Walmart added only about a quarter the square footage it did in fiscal 2007.

As growth slowed, Walmart let prices rise relative to competition to please investors with fatter margins. This was never the officially acknowledged plan, but suppliers for years have said margin growth was a high priority for buyers. Gross margins rose from 22 .9% in 2005 to 24.7% last year for Wal-Mart Stores as a whole. Now, Walmart is out to widen the price gap again with competing retailers, Mr. Duke said this week.

While U.S. CEO Bill Simon has rededicated Walmart to EDLP, some suppliers believe it's "a dead strategy." Leon Nicholas, managing director of Kantar Retail, sees another problem with EDLP: It's boring, particularly as Groupon-like sites train a new generation of consumers to expect deep discounts and a constant deal stream.

But Walmart isn't about to give up on EDLP. It sees the changes made a year ago, which included bringing back thousands of delisted products and piling promotional merchandise into aisles again, as working.

Last quarter's 0.9% same-store-sales decline was the least bad in two years. Both same-store sales and traffic improved sequentially during the quarter. This indicates Mr. Simon's plan "has traction and is gaining momentum," said a spokesman. Customers are consolidating trips to save on gas, making Walmart's supercenters more important than ever, he added.

But, despite a weak economy, all of Walmart's leading competitors, ranging from its own sibling Sam's Club to Kroger Co., drug chains, dollar stores and Target , posted better, positive results.

Mr. Simon noted on the retailer's Aug. 16 earnings call that Walmart's 189 supermarket-size Neighborhood Market stores have had positive same-store sales for 15 straight quarters, with sales up 3% last quarter. Trouble is , that wasn't enough to overcome falloff from nearly 3,000 supercenters, which are 86% of Walmart's U.S. square footage. And the better relative performance of the small stores supports Mr. Nicholas' theory that the supercenter heyday is over as boomers age out of child-rearing years, millennials delay having kids and big stock-up trips decline.

That suggests the need to build more small stores. And so the cycle continues.

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