The key to Wal-Mart‘s (NYSE:WMT) success has been its strategy of offering products at the lowest prices in the market, which it refers to as ‘Every Day Low Price’ strategy. This has allowed the retailer to acquire an enormous customer base in the U.S., serving more than 100 million customers every week. One of the strongest contributors to this huge store traffic is Wal-Mart’s grocery business. Groceries are a basic need of consumers and are somewhat resilient to economic headwinds. Moreover, they have a higher selling frequency as well as the ability to enhance cross sells.
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While it makes perfect sense for Wal-Mart to expand its groceries, being a low margin business, it puts negative pressure on the retailer’s profits. Over the past few years, the company’s gross margins have declined gradually as the share of groceries in its overall revenues has gone up. Since the company’s future plan includes focus on its grocery business, we expect the margins to continue to decline. However, this can have a positive impact on its sales growth.
Our price estimate for Wal-Mart stands at $81, which is just ahead of the market price.
Why Is Grocery Business Important For Wal-Mart?
Consumer spending on groceries can be classified as non-discretionary and is therefore less correlated to macroeconomic factors. During the recession of 2008-2009, consumer spending on food and beverages remained more or less stable according to economic data from the Bureau of Economic Analysis.  Also, groceries are a big market segment, accounting for annual sales of over $560 billion. 
This is a favorable product category for retailers because customers that tend to visit a store to buy groceries are 10 times as likely to visit a pharmacy or a general retail store.  This improves cross sell and increases the customer’s overall basket size, which has a positive impact on the retailer’s sales. For example, at Target (NYSE:TGT), which does not have a full-line grocery, stores with a partial-line of groceries in them had higher overall sales than stores without groceries.  This is the reason why Wal-Mart has been focusing on increasing the share of groceries in its overall business.
Share Of Groceries In Wal-Mart’s Business Is On The Rise
Wal-Mart has been aggressively converting its Discount Stores to Supercenters that offer a complete range of grocery items. Additionally, it has been increasing the number of grocery SKUs in its existing stores and launching in-house brands such as Great Value, which are cheaper than national brands but comparable in quality. As a result, the share of groceries in Wal-Mart’s total revenues has jumped from 24% in 2002 to 55% currently.
Going forward, we expect Wal-Mart to continue to push into groceries as it expands its smaller format Express Stores and Neighborhood Markets in urban areas. Although these stores offer a limited number of SKUs, most of them are grocery items. Last year, the retailer opened 76 such stores and planned to add another 100 this year. For the next year, Wal-Mart plans to open 235-265 stores in the U.S., out of which 120-150 will be Express stores. The main idea behind this strategy is to continue expanding in the U.S. and snatch some grocery market share from local dollar stores. This will not be difficult for the company given that it offers groceries at lower prices than most dollar stores.  Therefore, we believe that the share of groceries in Wal-Mart’s revenues will continue to rise in the future.
However, This Is Putting Downward Pressure On Gross Margins
While groceries provide the opportunity to generate high revenues, it is a lower margin business. Over the past four years, Wal-Mart’s gross margins gradually declined from 27.3% to 26.7% as the share of groceries rose from 53% to 55%. Going forward, as the share of groceries continues to rise, we expect the margins to decline in the near term. We forecast Wal-Mart’s gross margins to stabilize at 26.2% in the long run as its strong negotiating power and vendor collaboration can help it reduce the cost of goods.
However, if the increased share of groceries along with rising labor costs in China drag the retailer’s margins to 24.5% by the end our Trefis forecast period, there can be 5%-10% downside to our price estimate.Notes: