The Implications of Wal-Mart's Warning

The retail giant lowered its profit forecast for the rest of 2007, in part because of the rising economic pressures on consumers

Maybe it's time to start worrying about whether American consumers can keep propping up the U.S. economy.

On Aug. 14, Wal-Mart Stores (WMT) provided a bleak outlook for the second half of the year, even as it reported record sales and profits for the second quarter. H. Lee Scott Jr., the company's president and chief executive, said that consumers slowed their spending markedly in the last weeks of the quarter, as rising interest rates and gas prices took a toll on paychecks. "Consumers are under difficult pressure financially," he said, in an unusually grim conference call, prerecorded for investors and analysts. "Consumers are running out of money by the end of the month."

Scott didn't place all the blame for the company's difficulties on consumer concerns. He said that the company has also created problems for itself, particularly in merchandising, as its push into upscale apparel and home furnishings has floundered. "Although some people will report that Wal-Mart has had record sales and earnings, our underlying operating performance this quarter is not what we expect of ourselves and not what our shareholders expect of us," Scott said. "For the remainder of this year, our management team is focused on inventory improvements, delivering quality products at low prices, and store execution at the highest standards."

The Housing Downturn Strikes Spending Habits

But what spooked Wal-Mart shareholders and investors more broadly is the idea that the American consumer, free-spending for years, may now be cutting back. Rising interest rates are hurting those with adjustable-rate mortgages and other debts, while the downturn in the housing market has made many Americans feel less well off than they did just months ago. At the same time, the stock market is gyrating wildly and gas prices have remained stubbornly high. "We are in a tough economic environment with the consumer being affected by the housing market, tightening credit, and even gas prices," says Michael Niemira, chief economist for the International Council of Shopping Centers, which tracks sales at shopping centers.

Wal-Mart shares dropped 5% on Aug. 14, to close at $43.82, while the Dow Jones industrial average tumbled more than 200 points, to close at 13,028.92 (see, 8/14/07, "Stocks Tumble on Credit Fears, Wal-Mart"). The news came one day after Sears Holdings (SHLD) reported disappointing results for the second quarter, and Chief Executive Aylwin Lewis said, "The housing market slowdown and other economic pressures have presented a noticeable headwind to the business."

For the quarter, Wal-Mart reported an 8.8% increase in sales, to $91.99 billion, propelled by 16% growth in its international operations. Net income increased 49%, to $3.10 billion, although profits in the year-earlier period had been reduced because of a charge for the sale of its German operations. Income from continuing operations in the second quarter rose 4.1%, to $3.11 billion.

Wal-Mart's Pessimistic Outlook

Yet while the quarterly performance was solid, the outlook for the rest of the year is difficult. Wal-Mart says it now expects to report earnings per share from continuing operations of between $3.05 and $3.13 for the full fiscal year. It had previously said that it expected to earn between $3.15 and $3.23 per share.

"The company's current earnings projections reflect the need to continue to improve our underlying operating performance," said Thomas Schoewe, the retailer's executive vice-president and chief financial officer, in a statement. "This guidance also reflects the economic trends that have developed in many of our major markets."

Coming from the world's largest retailer, such dire pronouncements have a broad impact. Still, Brian Bethune, an economist at analysis firm Global Insight, disagrees with the dark picture. Bethune points out that competitors like Target (TGT) and J.C. Penney (JCP) have performed well in these same economic conditions. "Wal-Mart executives are seeing it through their own dark glasses because they are struggling with their own ongoing problems with product positioning and marketing," says Bethune. "Yes, the low-income consumer is struggling, but it's certainly not as severe as Wal-Mart would suggest."

"Too Far, Too Fast"

Economists say that the picture is hardly rosy. Consumer spending is slowing, particularly in those states where the housing downturn is most severe, including California, Florida, and Arizona. But Niemira points out that Wal-Mart had been struggling long before the housing market ran into trouble. "Wal-Mart's woes preceded this tough consumer spending cycle that started around February this year," he says. "Its current results are a reflection of issues that it's dealing with within the company."

CEO Scott acknowledges that the company has made missteps. In an interview with BusinessWeek earlier this year, he said that the company has struggled because it tried to move "too far, too fast." into upscale markets. "We are defined by our customer, not by us," he said. "And we can't wake up one morning and say we're going to be something different and something more to you and not earn it. We just can't." (See, 3/30/07, "Wal-Mart: 'On the Side of the Angels.'")

Now, as American consumers struggle with rising interest rates and credit market woes, Scott says there's an opportunity for his company. "Many customers around the world continue to be under economic pressure, and they expect Wal-Mart to be their advocate," Scott said in the company's conference call. "We will continue to be the undisputed price leader."

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