Sunday, May 25, 2008

Walmart's (WMT) Annual Report

Walmart's (WMT) annual report is clear, concise, and so well-written, it could function as a lesson in basic accounting terminology. WMT actually explains why it includes one measure of accounting over another, and then provides both numbers, GAAP and non-GAAP. In providing more than the usual information, WMT ends up giving its readers some accounting definitions that make it easier to understand financial statements.

For example, what is the difference between diluted and basic earnings per share? "Diluted" earnings per share include options and share-based awards and therefore provide a more complete picture of how the company is doing.

On the very first page, Walmart actually tells you exactly what its free cash flow is, which is an important measure of a company's success. (If consumers aren't buying your products, your cash flow will decrease--and that one number can tell you if your products are in demand.) "Free cash flow" is basically net cash from operations. Walmart's cash flow increased 25% from the previous year. In addition, Walmart had more than $100 billion--yes, billion, with a "b"--in sales in just the fourth quarter alone.

There was also some discussion of ROI (return on investment, non-GAAP) vs. ROA (return on assets). Typically, GAAP numbers are more accurate, but that's not always the case. After the era of pro forma earnings, which allowed Enron to keep growing based on speculation about how it would do in the future, I always look at GAAP numbers. GAAP numbers can can still be fudged, but if I'm going to be fooled, at least I'm going to be fooled by looking at the most realistic numbers.

WMT has most of its stores in TX, FL, and CA. With the mortgage crisis, will WMT benefit from more traffic in its FL and CA stores as consumers become more price conscious?

I recommend that you read Walmart's annual report first if you've never read one before. I am still deciding whether I can go to the annual meeting in Fayetteville, AR. After all the hoopla in the press about Walmart, it was interesting to read about it in its own words. WMT's 10K front cover says, "We save people money so they can live better." It's interesting when a large, powerful retail company focuses its mission on saving consumers money rather than appealing to the quality of its products or some other non-concrete advantage, but it's hard to argue with more cash in your pocket at the end of the day.

Many economists have said that WMT helps the poor because the poor buy more fixed, or "hard" materials, like shampoo, cleaners, detergent, razors, clothing, etc., which are cheaper at WMT, while the rich buy more expensive items or high class services (like vacations and Gucci), which Walmart doesn't sell. I agree with that assessment, but the unresolved question is whether WMT negatively or positively affects the growth of a middle class in the areas it operates. At this point, I don't think that WMT affects the middle class in areas that have diversified economies. WMT may drive out smaller mom-and-pop retail stores, but when was the last time anyone in a large city bought their detergent or razors from a mom-and-pop shop? If smaller cities lose small businesses because they sell the same things WMT does, but at higher prices, does the benefit of cheaper prices offset the unemployment of the small business's employees (who now probably also lack health care)? It probably depends on how many small businesses are displaced.

Most likely, as long as WMT doesn't expand its offering of services, like haircuts, food service, gourmet coffee service, massages, cell phone sales and service, tax preparation, car repair, or other non-concrete products, the average small business won't suffer or will survive by competing based on quality. For example, I doubt the local Panera Bread franchise or the local gourmet coffee shop is concerned about WMT, even if WMT did decide to expand its food service operations. Large, less efficient corporations that sell products rather than services, like Circuit City, are the real entities who should be concerned about Walmart.

With its tens of thousands of employees, WMT might believe that if it offers full benefits to part timers, it might not be able to sustain its growth. Many have argued that WMT is a burden on local resources because its wages are too low and it doesn't offer medical benefits to all its employees, causing them to go on the dole. WMT may not be overly concerned about its employee benefits because its competitive advantage isn't based on its employees. (Sadly, lower level retail employees are not difficult to find, especially in the developing countries where WMT is expanding.) WMT's advantage is that no one its size has been able to replicate its handling of its worldwide supply chain and inventory management, which allows WMT to offer lower prices by being efficient and leveraging (arbitraging?) global operations. This is where the problem of capitalism comes to light--what is best for shareholders isn't always great for employees. The case of whether to criticize WMT for not offering full benefits is especially difficult, because WMT isn't polluting like Exxon Valdez or forcibly demanding its American employees work in dangerous conditions like coal mines. Therefore, you could argue that WMT deserves to be left alone, because if you don't like its products or way of doing business, you don't have to shop there, and WMT doesn't affect you directly unless you choose to work for them.

Also, at the end of the day, WMT's numbers don't lie--$100+ billion in sales in just four months means enough people believe in the company and its products to continue shopping there, and until that changes, WMT opponents are basically resorting to the argument that because a company is big and can afford it, it should offer more benefits to its employees.

I run a small business. If a non-customer came to my door and told me how to run my business, I'd feel that it was my right to choose my own path, because it was my money and time at stake. Why does that principle of the "right to be let alone" change just because Walmart makes more money than I do? I don't know Walmart's requirements for receiving benefits, but Walmart may want to offer its employees working at least 24 hours per week and with 6 months of tenure some kind of subsidized health care coverage. Costco (COST) demonstrates that you can grow and offer reasonable benefits to employees. At some point, Walmart's sales will decline if consumers gravitate to COST because of its presumably happier, more motivated employees, or better reputation. Few consumers want to save a few bucks by breaking the backs of local employees. At the same time, Walmart has many long time employees--by one count, they had 20,000 associates who had been with the company 20+ years. That's a reputation for retention not too many companies can boast.

See 2007 report of annual shareholder meeting:

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