Too Big for Its Riches

That great American retailing machine, Wal-Mart Stores, just keeps rolling along, doesn't it? Even in the current "challenging retail environment," Wal-Mart announced last week that sales in the fiscal year ending Jan. 31 increased a respectable 16% to $191.3 billion, while earnings hit a record $6.3 billion—a 17% jump. But hidden amid that thicket of good news is a thorny problem: Wal-Mart's European operations aren't reaching the levels of growth needed to make the company's expensive leap across the pond pay off. "Wal-Mart has not yet succeeded in markets that it cannot drive a truck to," says London-based investment bank WestLB Panmure in a recent analysis that concludes the retailer hasn't successfully replicated its American business model in markets not adjacent to the U.S.

Nonetheless, president and ceo Lee Scott calls Wal-Mart's international operations—which also include Canada, Latin America and Asia—a "bright spot," where operating profits were up 36% to $1.1 billion. Profits of $1.1 billion may sound robust, but Wal-Mart has invested at least $17 billion overseas, giving it a return of just over 6%. "You'd be better off putting the money in a bank—or under a mattress," maintains Richard Hyman, chairman of British retail consultancy Verdict Research. Indeed, in the U.S., Wal-Mart regularly enjoys a return on investment of around 23%.

The world's biggest retailer entered the European market in December 1997 when it bought Germany's Wertkauf chain of hypermarkets. Thirteen months later, it picked up a second German chain, Interspar. In June 1999 it paid $10.8 billion for Asda, Britain's No. 3 supermarket chain. Expectations were high that Wal-Mart would quickly become a major European presence by leveraging its super-efficient sales techniques, high-tech inventory-tracking systems and global sourcing prowess.

But in Germany, where its 95 stores command only a 1.1% share of the food-sales market, Wal-Mart is floundering in red ink. The company won't say what its German losses total—analysts peg them at a whopping $200 million a year—but admits profitability is at least two years away. In Britain, Asda is a successful, moneymaking enterprise, but analysts doubt it can realize the ambitious targets set by Wal-Mart to cover the high price of admission. In its fiscal year just before the acquisition, Asda had operating profits of $702 million, and Wal-Mart vows to double that by 2004. But that's unlikely when Asda's market share is 9.6%, nearly nine points below market leader Tesco—a gap that has changed little in five years, according to Verdict.

Among the problems bedeviling Wal-Mart in Europe are the loss of key senior managers, cultural differences, an inability to get inventory systems running quickly and fully, and strong competitors. In Germany, it's hard to be the lead price-cutter when retailers historically offer low prices and operate within ultra-tight margins.

But Wal-Mart's real problem in Europe is a lack of scale. In the U.S., where it can shift massive volumes of stock through its mammoth supercenters, the company wrings price concessions from suppliers and passes on the savings to customers. Wal-Mart's 3,118 stores in the U.S. average 38,109 sq m each; Asda's 241 outlets are barely one-third that size. Moreover, Asda is primarily devoted to food, not higher-margin general merchandise.

Wal-Mart is trying to rectify things. This year alone it's spending $648 million to add 182,927 sq m of sales space in Britain by building nine new stores and expanding four others. But that's not enough, Hyman insists. "They have got to drive more volume through the business, and that means many more stores." Expansion could be hampered, though, by zoning restrictions that limit store sizes in both Germany and Britain. Acquisitions are a possibility, but pickings are slim. In Germany many rival chains are owned by families that are in no mood to sell. Potential tie-ups in Britain may not pass muster with regulators.

Scott accentuates the positive, saying there are hopeful signs in Germany: an increase in comparable (same-store) sales growth and better gross margins. But Nikolai Baltruschat, European retail analyst at Deutsche Bank, remains skeptical: "If you come from a base that far below the industry average, it's easy to report favorable growth."

History shows that Wal-Mart is smart enough to devise solutions and rich enough to carry them out—especially since Europe is key to its plans to become a global player. Michael Poynor, retail director at London consultancy COBA Group, says Wal-Mart could achieve the scale it needs by taking a pan-European tact and scooping up another big chain in a third country. But that will take more time and money. And investors may go along for the ride for only as long as the good times continue to roll at a double-digit pace in the U.S.