Profitability analysis and WalMart's suppliers

WalMart, the world's largest retailer, is legendary for squeezing price concessions and ever greater operating efficiencies from its suppliers. To what extent do such concessions hurt financial performance?* One recent study has found that suppliers identifying WalMart as a primary customer financially underperformed compared to companies that did not identify themselves in this way. Especially revealing is the observation that among the 10 largest suppliers to Walmart in 1994, four subsequently went bankrupt and a fifth was taken private as it was failing. But should suppliers just say "no" to WalMart? is it simply too big to ignore?

Consider the case of Dell, the computer maker. While the overall computer market has been growing, Dell's own share of that market is falling. In a first step toward transforming its model of direct selling to consumers, the company announced in May 2007 that it would begin selling two models of its low-end Dimension line through more than 3000 Walmart stores in the US and Canada. Dell's share price fell by 1.4% on the news, partly because of analyst fears that the company might see a further deterioration of its already battered profit margins.

Still, some analysts viewed the move favorably. "They got products on the shelf of the no I retailer in the world, according to one such analyst. Dell is finally listening to its

customers."

Bain & Company, the management consultants, have studied the effect of doing business with WalMart. The fact of the matter is, the way WalMart is continuing to grow means that our clients cannot grow their business without finding a way to be successful with WalMart," according to Gib Carey, the partner in charge of the study. We have clients out there who would like that not to be true. But we think that WalMart is an essential retailer, in a way that no other retailer is."

To understand the effect of WalMart on supplier profitability, Bain staffers conducted an analysis of 38 publicly traded companies that did more than 10% of their business with WalMart. Bain also analyzed the performance of 20 companies in similar industries that were not significant WalMart suppliers, as a control group. The analysis produced a consistent pattern. For every percentage point of increased business these companies were doing with Walmart, operating margins declined to some extent. That is, the more businesss a company does with WalMart, the less profitable each sale is. It may be preasure," says Carey, or it may be that companies are intentionally letting some profit margins decline to aggressively grow their business with Walmart."

According to the Bain study, companies doing 10% or less of their business with WalMart had operating profit margins of 12.7%. Companies that became what Carey calls "captive suppliers" to WalMart selling more than 25% of their output to WalMart - see their profit margin cut almost in half, to 7.3%. What we've found as we've continued to work with clients," says Carey, is that WalMart is really forcing companies to either get their act together, or get crushed."

Required

a. If "profitability" (i.e., operating margin) is lower for companies that derive a lot of their business from WalMart, why sell to WalMart? What logical reasons can a company give for such a practice if greater sales to WalMart are associated with lower margins?

b. How would a company know if an expected decline in profit margin was a price worth paying for WalMart's business? Be specific. What measures would need to be considered to address this issue?