China Demands Better Quality From Wal-Mart

The Pulitzer prize is the most prestigious prize in investigative journalism, and last year it was awarded to David Barstow and Alejandra Xanic von Bertrab of the New York Times for breaking a story that implicated Wal-Mart Stores (NYSE: WMT  ) in a case of foreign bribery. The story alleges that Wal-Mart paid $24 million in bribes to obtain licenses to expand operations in Mexico. 

In response to the story, the Department of Justice and the Securities and Exchange Commission have brought charges against the company, and the case is expanding into China, among other countries.

In a completely unrelated story, on Jan. 31 Wal-Mart announced that it will upgrade its vendor compliance process in China. This announcement came shortly after a news story that aired on China Central Television, or CCTV, a state-owned television station. The story sounds eerily familiar -- CCTV criticized Wal-Mart for circumventing licensing requirements that safeguard the public against fraudulent vendors. Apparently, the broadcaster reviewed more than 200 company documents which showed Wal-Mart managers signing off on 600 unlicensed products that entered the market.

What exactly is vendor compliance
A vendor is a supplier of products or services, generally viewed as a business or trading partner. Some companies work with two or three vendors, but massive retailers like Wal-Mart maintain hundreds of vendor relationships. Vendor compliance refers to the set of rules the vendor must follow to do business with the retailer, and this is just one aspect of a good supply chain system.

Vendor compliance is also important in the case of security, as Target (NYSE: TGT  ) found out over the holidays. A large organization makes the perfect target -- excuse the pun -- because it has thousands of suppliers. Rather than attacking the corporate giant directly, hackers attack its most vulnerable suppliers. Target's breach occurred because hackers stole credentials from a registered vendor in its supply chain. According to Torsten George, VP of marketing at Agiliance, approximately 80% of data breaches originate in the supply chain.

Dollar General (NYSE: DG  ) is one of the best-performing discount retailers in the industry. Total sales increased 10.5% and same-store sales increased 4.4% in the third quarter. In 2012, Dollar General began the implementation of a new supply chain solution to "assist in promotional and core inventory forecasting, ordering, monitoring and improving inventory visibility from purchase to receipt to maintain efficient levels of inventory." Perhaps this was Dollar General's secret weapon in 2013.

So, what motivation does Wal-Mart, which operates over 400 stores and warehouses in China, have to approve vendors without licensing?

Surprise, surprise

File:Don Knotts Jim Nabors Andy Griffith Show 1964.JPG

Publicity photo from the television program The Andy Griffith Show. Pictured are Don Knotts (Barney Fife) and Jim Nabors (Gomer Pyle).

According to the CCTV broadcast, the motive is profit -- surprise, surprise. Evidently, Wal-Mart was deliberately allowing higher-margin vendors to sell product without the proper documentation or licensing. We're talking about labels that reflect the correct ingredients, tests or reports that have been completed by the government, manufacturing permits, records substantiating health claims such as "world-famous," papers on intellectual property, and China's Compulsory Certificates.

"Ultimately the boss at Wal-Mart is the customer and what they deserve is to trust us," said Raymond Bracy, the SVP of corporate affairs at Wal-Mart China. He goes on to say, "We are working very hard on their behalf to provide products that are safe and authentic."

To date Wal-Mart hasn't been penalized by any regulatory authorities, such as China's State Administration for Industry -- the equivalent of the U.S. Food and Drug Administration, but the costs of compliance add up.

Compliance has its costs
The truth is that Wal-Mart has been entrenched in all things compliance ever since the New York Times broke the story.

"Recently, we made improvements to our compliance programs around the world and have taken a number of actions with respect to our processes, procedures and people," said the company on the last earnings call. "We aligned our corporate structure to have global compliance, ethics, investigations and legal functions under one organization. We also named a Global Chief Compliance Officer and a Chief Compliance Officer for Walmart International."

All of these actions cost money, which according to the 10Q, was $224 million in the first nine months of 2013. This is also one of the stated reasons that costs outpaced sales for the first nine months of last year -- operating expenses increased 2.2% while net sales increased 1.7%.

The other issue is public relations. According to Wal-Mart, news articles and media publications "could impact the perception among certain audiences of the Company's role as a corporate citizen." Indeed, comp store sales for Wal-Mart China grew only 0.4% in the third quarter, driven almost entirely by price increases as traffic declined 7.6%.

The Foolish bottom line: compliance costs money
These two events point to a system of corruption at worst, and poor controls at best. We may never know if Wal-Mart's motivation for approving unlicensed vendors is greed or just poor management, but one thing is certain -- the company is already facing multiple allegations of international bribery in relation to licensing and it's taking its toll on the bottom line.

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Celan Bryant

Celan follows the energy and retail sector. When she isn't reading a 10K, she's watching Ancient Aliens or playing with her dogs. @celanbryant on Twitter.

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