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Thursday, October 22, 2015

The Economics of Strategy: Walmart's Senescense

Michael Smitka

Washington and Lee University

October 22, 2015 WREL Update

Today there's no "news" – nothing in the latest economic data is (to me) surprising – so instead I'll speak on topics tied to my teaching, and close with a brief note on United Way of Rockbridge. This term I'm teaching three very different classes, a senior "capstone" focusing on modern macroeconomics, a course on China's economy, and the other on the economics of business strategy. On air I spoke on two topics. One was Walmart as an exemplar of strategy. Yesterday I also "taught" a paper of Milton Friedman's, and so I started a multiweek series examining the evolution of "rules versus discretion" in policymaking. But for this blog post I'll limit myself to Walmart.

...Walmart is left as a bottom-feeder…

First, Walmart's strategy was to use economies of scale to gain a competitive advantage in its initial market, rural America. As long-time residents of the Rockbridge area will recall, Lexington used to have a hardware store on a prime piece of Main Street. There's still a building supply business a couple blocks away, back near W&L's Lenfest Center, across from where the railway station was located, back in the days when every town had train service. Buena Vista still has a couple hardware stores, and in Lexington there's one off of Nelson Street, behind Wendy's and Frank's Pizza (which I like), and the Rockbridge Farmer's Coop at the south end of town.

As hinted at, the geography of hardware stores, and the local dry goods store and so on, dated back to when roads weren't particularly good and many people lacked cars. Such stores had a local monopoly albeit in a market of limited size; they didn't discount. Their focus on a local market meant they carried a restricted range of goods, so you might have to order what you needed. Their competition was not internet sales, but the Sears, Roebuck and Company catalog, which provided parcel post delivery that might prove cheaper than your local store, and offered a huge array of products that a small town retailer couldn't begin to touch. (Aside: only later did Sears move to brick and mortar – will history repeat, with Amazon stores in every town?)

Walmart took advantage of better roads and pervasive car ownership to set up larger stores with greater variety, and to use scale to allow it to offer these at a lower margin. It could staff lightly, by locating outside of towns it could manage its real estate costs while providing better parking and road access, and it chose to offer hours far longer than those of any downtown retailer. Call these economies of scale plus the ability to push against the operating limitations of small town retailing. In addition Walmart offered greater convenience by carrying in one location what would in general have been spread across several stores – basic clothing, hardware, and other "hard" goods. Eventually this expanded to include a pharmacy, groceries (with the launch of Supercenters in 1988) and a full line of consumer electronics. No single department could match those of a specialty retailer, and you couldn't get the service provided by the local hardware, which could advise on tools and materials. But a large proportion of sales volume was of common items where customers didn't need (and maybe didn't want) such service. And there was the convenience: quick in and out for three items, which might have required you to visit three stores downtown during the busiest part of your day. This we could term economies of scope.

Walmart pushed this strategy for their first couple decades, gradually expanding across rural America while avoiding suburban locations. (You still can't find Walmart in urban locations – they have zero stores in Detroit, zero stores in New York City.) They faced no competitors. K-Mart, for example, began as the Kresge Five-and-Dime chain, located in big cities, and gradually expanded to the suburbs. They never managed that transition well, the operational efficiencies never matched those of Walmart. Sears set up stores in urban areas, and then expanded to malls, but was unable to leverage its catalog strengths to create a distinctive bricks-and-mortar strategy in rural areas.

Walmart also offered operational efficiency. In the retail world, their management information system was matched only by that of 7/11 in Japan. When you went to Walmart, you could find what wanted; they did not stock out. In contrast, with K-Mart you could never be sure they'd actually have what you wanted on their shelves. Their stores were smaller, carried a narrower range and otherwise were not up to their competition, and in particular to Walmart.

Once Walmart had filled rural America, however, they started losing steam. While they were better than K-Mart, they did face competition. Real estate was more expensive, and urban consumers were more prosperous and had varied tastes. Walmart couldn't tap the full breadth of the population, and instead had to bottom-feed. In addition, expansion slowed.

...senescence will be followed by debility...

Meanwhile they'd become a mature big business, with a headquarters staffed by professionals in finance, marketing and other functions – that is, not staffed by people with hands sullied from initially working retail. They brought new ideas and technicals skills, but not necessary better ideas, or the ability to understand how their expertise contributed to the overall position of Walmart. In short, they could optimize their narrow function while losing sight of what the business was about.

That structure in general meant more rules and regulations, and less delegation of authority. Our local store can't readily adjust staffing when local conditions give them busy periods other than those built into regional and national operating plans. Ordering is at the regional level; garden supplies come in line with the growing season in Richmond and Virginia Beach, which means inventory arrives too early in the season to plant. All of this works to the advantage of smaller retailers more attuned to our area, or focused retailers (Lowes).

Then there's the stock market growth imperative, that each quarter ought to have higher profits than the preceding one. Why management should respond to this is not so clear. Some comes from the perverse incentives that pay and bonuses are more closely linked to scale than to profit margins. Put simply, it's better in pay and prestige to be an exec in a big business than a medium-sized one. At some point, though, Walmart scaled out, and additional expansion leads nowhere, or nowhere good. Walmart tried the international side, and lost billions in Germany, Korea and Japan, among others. (While they exited from Germany, they maintain ownership of the Seiyu chain in Japan, most of whose stores are small and in poor locations for today's suburban, car-driving population.) My sense is that they do well only in Mexico and secondarily in Canada, due to organic expansion. In other countries they tried the acquisition route, and so were unable to leverage such strengths as their US experience might afford. We'll see how they do in China...

Now if organic expansion is slow – adding a store doesn't add a visible amount to sales – and the merger and acquisition route has hit a dead end, then the only route remaining is to cut costs. When your business model was based from the start on low costs, that requires cutting services. Staffing means shelves don't get restocked, and checkout lines can be unbearably long. Middle management is cheapened, without authority you don't have to spend time on hiring and training good people, or encouraging those you have to develop in their jobs. All of this rebounds into a poorer customer experience.

And I see no way out. There's no room for expansion geographically. Higher-margin goods face the rise of online retail. Specialty chains and Target pull away the more desirable customers, aided and abetted by the shopping experience Walmart provides. So Walmart is left as a bottom-feeder. While they could spend more, that would hurt profits for a period of years, and might not be well-managed if those in Bentonville want to remain as decision makers. While I'm not aware of any retail concept that might eat into Walmart's core rural markets, I'm afraid that the management focus on growing profits means they will be neglected, with a cumulative impact on their profitability. My expectation is that senescence will be followed by debility.

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For 2016 United Way of Rockbridge will provide grants for 22 projects to be undertaken by 18 community-oriented non-profits. One focus are critical needs such as food, shelter, and assistance to the disabled. Our other focus is on having a positive long-run impact on our community through improving the preparation of children for kindergarten and elementary school. Note that to be useful to these groups, who have to draw up their budgets and operating plans, we have to make our funding decisions well in advance of when we actually hand out money. So any amounts I mention are for CY2016.

Each week I'm speaking briefly about one of these organizations; today it's Campus Kitchen at Washington and Lee. They began in 2008, and work with the dining services of Washington and Lee, Virginia Military Institute, Carilion Stonewall-Jackson Hospital, and Walmart to see that food does not go to waste. To date they've repurposed 200 tons of food to provide almost a quarter million meals to families in the Rockbridge area. During the course of the year, they'll typically get over 300 individuals volunteering to collect and repackage food and for certain groups whom they serve, to cook meals.

This coming year UWR will fund two projects. One is $2,000 for their "backpack" program in cooperation with local schools, in which they send groceries home with children whose families face challenges in putting food on the table. The second project is $2,000 for their mobile food pantry, which provides food to outlying areas of the county that are not near any of the existing food pantries.

As with other projects, we evaluate their paper application, and then arrange for two reviewers from the community – volunteers including but not limited to members of the United Way board -- to visit each group. Unfortunately we can seldom provide groups with all the money they request; we instead strive to allocate to generate a good impact for the money we can allocate.

Later in the fall I'll have information on the progress of our 2015-16 Annual Campaign, which seeks to raise $250,000, slightly more than we managed last year. Please consider helping us toards our goal of "Building a Caring Community". Some of you will receive appeals through your employer. Even a dollar per pay period is meaningful – the groups we support leverage volunteers and other resources, so that even seemingly small amounts make a difference to someone. More generally, please visit our web site. You can use our "Donate Now" function to make a contribution with a credit or debit card. It's secure – we never see your card number, and the data isn't stored. We also provide details on our grants, our finances and Board. And our address, in case you'd like to contribute by check...