The unending woes of Lee Scott

The king of retailers has lost ground to competitors since its current CEO took over. Wall Street is starting to lose patience, says Fortune's Jon Birger.

By Jon Birger, Fortune senior writer

(Fortune Magazine) -- The world's biggest retailer had a lousy 2006.

There were personnel problems, like the resignation of Sam's Club marketing head Mark Goodman and the embarrassing ouster of Julie Roehm, the young advertising whiz Wal-Mart had hired away from DaimlerChrysler.

There were legal troubles: In October a Philadelphia jury ordered Wal-Mart to pay $78 million to a class of 185,000 workers who claim they were denied breaks and forced to work off the clock. There were also business woes: The company took a $900 million charge after its forays into Germany and South Korea turned sour.

Same-store sales growth turned negative in November before rebounding to 1.6 percent in December - ahead of analysts' predictions of 1 percent, but still skimpy. (Same-store sales at Costco (Charts) and Target (Charts) were up 9 percent and 4.1 percent, respectively.) And Wal-Mart's stock, currently about $47 a share, was flat in an otherwise strong year for stocks.

Then there were the public relations fiascoes. Wal-Mart (Charts) had to sever its relationships with political consultant Terry Nelson and former Atlanta mayor Andrew Young. Nelson had a hand in the race-baiting "Harold, call me!" spot in the U.S. Senate race in Tennessee, and Young, while speaking on behalf of Wal-Mart, accused Jewish, Korean and Arab shopkeepers of selling spoiled food to inner-city blacks.

Bad years do happen to good companies. But for Wal-Mart, 2006 was just another downer in a period of decline that's lasted seven years and overlaps the tenure of the company's current CEO, Lee Scott.

Unhappy investors

Wal-Mart's stock has fallen 22 percent since Scott took the reins from David Glass in January 2000 (the Standard & Poor's 500 index is down just 2 percent over the same period), wiping out $90 billion in market capitalization. Those are huge numbers, and at any other company there would be a groundswell of rage from investors - the kind that just cost Robert Nardelli the CEO job at Home Depot (Charts). (During Nardelli's six-year tenure, Home Depot's stock outperformed Wal-Mart's, 3 percent to minus 7 percent.)

At Wal-Mart there has been no uprising apart from some speculation in the retail trade press last summer that Scott's job might be in jeopardy because he had taken May off. (Wal-Mart denied the reports.)

Still, Wall Street seems to be losing patience. Among institutional investors unloading Wal-Mart shares last year were American Century, MFS, Marsico Capital and Chase Investment Counsel. Chase, an independent investment firm that operates the Chase Growth Fund, sold its entire four-million-share stake late last summer in favor of positions in Kohl's and J.C. Penney.

Asked what Wal-Mart could do to get back on track, Chase Growth manager David Scott (no relation to Lee) says, "I don't know. That's probably why I no longer own the stock."

There are those on Wall Street (though none would speak for attribution) who think Scott himself is the problem. "It's like he's forgotten what the business model was all about - driving the top line by relentlessly lowering prices," says one Wall Street analyst. "But you look at their margins, they seem to be getting away from that."

Indeed, Wal-Mart has been taking a bigger profit on each item sold. Wal-Mart's gross margins, according to Baseline, have increased to 25 percent this year from 22 percent in 1999, which appears at odds with the chain's historical commitment to "everyday low prices."

Others are more charitable. "If anything, I think investors sympathize with [Scott] for being under the gun the way he is," says Margaret Gilliam, president of Gilliam & Co. and a veteran retail analyst, who was close to the late Sam Walton and remains in touch with the Walton family. Sam's heirs, along with other insiders, control 40 percent of the company's stock.

"I know [Scott] has the support of the family," Gilliam says. She points out that Scott has been forced to spend a considerable amount of time fighting persistent (and unfair, in Gilliam's view) attacks by two union-funded anti-Wal-Mart groups - Wal-Mart Watch and Wake-Up Wal-Mart - who complain about employee pay and benefits (see "Attack of the Wal-Martyrs"). Those campaigns may have hurt. According to a 2004 McKinsey & Co. report, 2 percent to 8 percent of Wal-Mart customers surveyed have ceased shopping at the chain because of negative press.

Getting back its mojo

It's true that Scott faces huge challenges. With expected sales of $350 billion for the fiscal year ending this month, Wal-Mart is such a behemoth that increasing the top line by 10 percent means adding $35 billion in yearly sales. That's roughly equal to the combined revenues of Staples, Barnes & Noble, Starbucks and Nordstrom.

And Wal-Mart under Scott has done some things right. Its green strategy - which includes everything from cutting back on packaging to selling more energy-saving light bulbs - has generated positive press, deservedly so (see "The Green Machine").

Scott himself has come out of the Bentonville bunker and made himself more accessible to the public - although he declined to be interviewed for this article. Scott also deserves credit for knowing when to cut his losses in South Korea and Germany. And unlike Home Depot's recently deposed Nardelli, Scott has neither a garish pay package nor a reputation for imperiousness. None of that, though, has budged the stock.

How can Wal-Mart get its mojo back? Here are four ideas from Fortune interviews with analysts, investors and retail experts:

Spin off Sam's Club. Sam's Club was designed to compete against warehouse clubs like Costco. Costco, though, has run circles around Sam's, and warehouse club pioneer Sol Price offered an explanation in a 2003 interview with Fortune: "The biggest thing with Sam's was that it didn't have a free hand to compete with Wal-Mart."

Spinning off Sam's would be good for Wal-Mart shareholders. Not only do spinoffs typically outperform the S&P 500 - by as much as ten percentage points during their first two years - but the stock of the parent company fares better too. "

Companies do much better when they're run on their own," says retail guru and Wal-Mart bull David Berman of hedge fund Durban Capital. "The same CEO is going to be hungrier and working harder."

Stop trying to be a growth stock. Wal-Mart has lately looked for growth in upscale goods and expansion into Europe and Asia. The problem is, says UBS analyst Neil Currie, "when Wal-Mart travels outside the U.S., the scale advantage doesn't mean as much." And Wal-Mart is still trying to figure out how to compete with chains that offer better service on pricey items like flat-screen TVs. Bear Stearns analyst Christine Augustine, another Wal-Mart bull, says, "If they don't take any risk, they'll never move forward."

But Staples founder Tom Stemberg thinks Wal-Mart should "quit trying to be a growth company, stop being distracted by [Europe and Asia], and focus on the U.S., Canada and Mexico," says Stemberg, now a partner with private-equity shop Highland Capital. That would free cash for stock buybacks and dividends. "Instead," Stemberg says, "they've decided they're going to defy the laws of gravity by expanding to half the world and trying to go upscale in fashion."

Extend an olive branch to the haters. HSBC retail analyst Mark Husson's suggestion was the boldest we heard: Take a one-year "holiday" from earnings growth to increase pay and particularly benefits for employees. "I could write the press release now," says Husson, whose stock-picking prowess ranked among the top 5 percent of all analysts last year, according to StarMine. "'Having done the right thing by consumers for so many years, it's now time to do right by our employees. It will be good for America and good for our employee turnover as well.'" Husson says high turnover is hurting sales, especially of upscale items.

A splashy act of goodwill, says Husson, should also make it easier for Wal-Mart to expand in blue states, where efforts to open new stores have met the most resistance. Kentucky has three times as many Wal-Mart supercenters (61) as California (21). On a per capita basis, Wal-Mart is four times more concentrated in red states than in blue, whereas Target's stores are evenly divided.

Show some urgency. Perhaps what's most troubling about Wal-Mart is that neither Scott nor those around him seem to feel investors' pain. "Why would our CEO be on the 'hot seat' in a year where we've had record sales and earnings?" Wal-Mart spokeswoman Mona Williams asked Fortune in an e-mail. Williams blames the stock drop on Wal-Mart's 12-month trailing price/earnings ratio of 54 when Scott took over: "Was that a realistic number long-term?" (Wal-Mart's P/E is now about 17.)

When Scott does acknowledge problems, his diagnoses seem off. In an October meeting with analysts, Scott blamed Wal-Mart's surprisingly weak same-store sales growth on high gas prices and on store remodelings. HSBC's Husson says, "They've done remodels before - they should know what the effect is." As for gas prices, Scott predicted sales would rebound when energy prices fell. Prices did fall, from $3 a gallon in August to $2.30 in late December, yet Wal-Mart's slide in same-store sales growth continued, from 2.7 percent and 1.8 percent in August and September to - 0.1 percent and 1.6 percent in November and December. While December's number was touted as a rebound, it was well below the 3.3 percent retail average for the month.

Scott may yet turn things around, of course. Bets in China and India for instance, may start paying off. But Wall Street is not likely to put up with a 2007 from Wal-Mart that looks anything like the year that just ended.

Research associate Joan L. Levinstein contributed to this article.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.