A few years ago, Hewlett-Packard CEO Meg Whitman opined that executing a turnaround for an enormous business typically takes a full five years. Wal-Mart (NYSE:WMT) shareholders have recently learned just how true that statement was.
This week, the retail titan reported Q2 earnings that missed analysts' estimates. The company also cut its full-year earnings guidance and significantly slashed its e-commerce growth target for this year. In the past two years or so, Wal-Mart has made some savvy moves to fix its business. However, it will probably take several more years for it to return to sustainable growth.
Another earnings disappointment
On Tuesday, Wal-Mart announced that Q2 earnings per share came in at $1.08, down by $0.13 year over year. Analysts had been expecting EPS of $1.12. Revenue rose a meager 0.1% year over year to $120.2 billion, although it would have risen 3.6% excluding the negative impact of the strengthening dollar.
Wal-Mart admitted that it's facing significant macro headwinds in several major international markets. Meanwhile, it's facing unexpected cost pressures in the U.S. from increased "shrink" (items being lost or stolen), lower pharmacy margins, and a strategic decision to increase staffing levels to improve customer service.
All of these cost pressures came on top of the company's decision to raise starting pay to at least $9 for Wal-Mart associates as of April and its heavy investments in e-commerce. As a result, Wal-Mart now expects adjusted EPS to decline significantly, from $5.07 last year to a range of $4.40-$4.70 in the current 2016 fiscal year.
That said, there were some bright spots in the quarterly report. Comparable-store sales in the Walmart U.S. division strengthened once again, rising 1.5% year over year. Comp sales rose a stellar 7.3% at the smaller Neighborhood Market stores, which are about 42,000 square feet on average. Wal-Mart just wasn't able to turn this sales growth into profit growth.
Wal-Mart is working to address many of the challenges that hurt its earnings in the first half of 2015. It's putting more emphasis on loss prevention in its training. It also opened two new fulfillment centers last quarter and will open another two this quarter, which by Q4 will start to offset the costs of its e-commerce investments by reducing shipping costs.
That said, the management team acknowledged during the company's earnings call that many of the current challenges will continue in the short run. If anything, economic conditions outside the U.S. have been getting worse in recent months -- not better. Pharmacy margins will remain under pressure. And Wal-Mart has a long way to go to catch up in e-commerce.
Additionally, wage pressure will continue next year, as the Walmart U.S. division will ensure that all current employees are paid at least $10 an hour starting in February. The company is also in the midst of adding 8,000 higher-paying department manager positions to improve customer service, creating another source of cost pressure.
This turnaround will take time
Driving robust sales growth is challenging for a company as massive as Wal-Mart. However, it is absolutely critical for offsetting inescapable cost inflation.
Raising employee pay and increasing staffing were both necessary investments to enable this much-needed sales growth. Wal-Mart's Q2 results show that these initiatives are already starting to work. However, it may take a few years for the full benefits -- such as lower employee turnover, higher productivity, and more attentive customer service -- to really show up.
In the meantime, Wal-Mart has to swallow significant cost increases that will continue through the end of next year. It will probably take a few years beyond that for the Walmart U.S. operating margin to return to historical levels.
The same could be said for some of Wal-Mart's other ongoing initiatives. The company is aiming to energize sales growth at Sam's Club by attracting higher-income consumers with an improved merchandise assortment. This strategy has great long-term potential, but it could take years for Sam's Club to make real headway, given Costco's dominance in this market segment.
Similarly, the strong comp growth at Walmart Neighborhood Market locations in recent quarters shows that the company was right to focus its domestic growth on this format. Consumers clearly favor the smaller stores for most grocery trips. (Grocery sales didn't fare well in Walmart Supercenters last quarter.)
Yet for the second straight year, Wal-Mart is cutting back on its plans to expand this format. For FY15, the company planned to open 270 to 300 small-format stores at the beginning of the year, but it ultimately opened only 235. For FY16, Wal-Mart initially announced plans to open 220 more Neighborhood Markets. Now it plans to open 160 to 170 as part of a focus on "quality over quantity."
Thus, while Wal-Mart has a lot of promising initiatives, they aren't even close to offsetting the impact of its wage increase and other investments this year. Even next year, investors shouldn't expect much earnings growth, as higher payroll costs could wipe out the impact of sales gains.
As a result, Wal-Mart investors should settle in for a long slog. If everything goes according to plan, Wal-Mart could return to sustainable sales and profit growth a few years from now, leading to significant stock-price gains. In the meantime, there could be a few more apologies about the slow pace of the turnaround.