Wal-Mart Versus Amazon: 1 Winner, An Industry Of Losers

#-ad_banner-#The two titans of retail squared off last week in a discount smack down. The battle should have major  consequences for each other and the broader industry.

Amazon.com, Inc. (Nasdaq: AMZN) has amassed a $100 billion revenue base through a combination of solid execution and well-timed promotions. For example, its Amazon Prime service has created a strong base of loyal and sticky customers. Celebrating its 20th anniversary of that service, the company held a special “Prime Day” on July 15, with a range of discounts.

The move came as retail Wal-Mart Stores, Inc. (NYSE: WMT) is making its own massive online push. While Amazon was touting its sales event, Wal-Mart cut prices on thousands of products last week and is developing its own loyalty program, which will cost $50 a year. Walmart also lowered its minimum purchase for free shipping to $30 from $50 for the week’s promotions. Wal-Mart’s CEO even took subtle digs at Amazon and its pricey $99 per year membership fee.

These two warriors are officially in battle.

Tale Of The Retail Tape
In tandem with a steady consumer migration toward e-commerce, Amazon’s growth rate has vastly outpaced Wal-Mart’s growth. Yet while Amazon’s gross margin is higher at 29.5%, its operating margin of 0.2% is razor-thin as the company focuses on growth rather than profits. Walmart is able to use its strength in discount and efficiency in operations to drive a stronger operating margin of 5.6%, lower than other brick-and-mortar retailers, but much higher than its online rival.

Both companies keep extremely efficient inventory schedules and are able to turn their inventory quickly, allowing them to book profits on a massive quantity of goods sold.

Until now, the two firms have had no reason to go head-to-head for shoppers. Walmart is making strong progress into e-commerce, though, and that may be scaring Amazon into discount deals like its Prime Day. Wal-Mart grew e-commerce sales by 30% in 2014 to just over $10 billion.

Who Wins When Giants Collide?
While Amazon touted the success of its recent sales event, the company was lampooned in the media for a fairly tepid selection of products that were discounted.

By comparison to Amazon’s hodge-podge of deals, Wal-Mart offered a wide assortment of rollback specials on everyday items like paper towels, diapers, mattresses, TVs and smartphones. Wal-Mart offered tech deals on name brands like Apple, Inc. (Nasdaq: AAPL), RCA and Hewlett-Packard Co. (NYSE: HPQ), while many of Amazon’s deals were in less recognizable brands like Jarv, Blurex and Tweeds.

Yahoo Finance ranked the two retailers in four categories on their promotions: name brands, relevance, pricing and shopping experience, and they determined Wal-Mart to be the winner in all but pricing, where the two titans tied.

Amazon counted 44 million U.S. members of its Prime service at the end of June, up 57% from the same month last year. The company offers a 30-day free trial for Prime so some of these members may have been subscribers leading up to Prime Day. On the massive disappointment in Prime Day sales, it will be interesting to see how many subscribers the company is able to keep as free trials roll off.

From a business standpoint, Amazon may have lost some credibility with the discount crowd on its weak Prime Day sales. The company heavily promoted the event, and I doubt that future events will draw the same enthusiasm as shoppers remember their past experience.

Amazon has built its brand on service and convenience and does not appear to have a strong skill set in discount retail. Wal-Mart’s strength is in discount, which should enable market share gains as the retailer moves deeper into e-commerce. Amazon has always favored growth over profits and risks losing focus if it tries to compete with Walmart in the discount category.

On the heads-up battle, Walmart staged a major brand victory against Amazon’s Prime Day offensive, but the real loser may be the larger retail segment. Both giants can compete on price and still book strong earnings, even on lower profit margins. Other retailers may not have that luxury and could become collateral damage of a retail price war.

Higher operating margins are the only thing saving traditional brick-and-mortar department stores like Dillard’s, Inc. (NYSE: DDS) and Kohl’s Corp. (NYSE: KSS). If margins were to fall in a retail price war, their lower inventory turnover may not produce the earnings needed to stay in the black.

From an investing standpoint, Walmart is a clear winner on value with an enterprise value-to-earnings before interest taxes earnings and depreciation (EV-to-EBITDA) multiple that is less than a fifth of Amazon’s. Wal-Mart has room to grow in e-commerce, while Amazon has no physical presence in which to compete.

Shares of Amazon are up roughly 57% year-to-date, but the higher valuation elevates the risk of a selloff. Second and third quarter numbers may receive a boost from Prime subscriptions and sales around Prime Day, but the risk is that disappointment around the event could lead to lower growth in the fourth quarter.

Other retailers are clearly in the crossfire if Wal-Mart and Amazon continue to compete on a price discount strategy. Most other retailers do not have the scale to book profits on shrinking margins. A continuing consumer exodus to e-commerce will require cash investment in infrastructure and development, cash that many retailers don’t have.

Risks To Consider: As the two heavyweights in retail fight over market share, the entire sector may see shares slump on falling margins. Investors should consider hedging their long positions with short positions.

Action To Take –> Shares of Wal-Mart look attractive on the company’s win over Amazon’s Prime Day event, and the retail giant is well-positioned to continue its push into ecommerce. While Amazon should be able to report strong growth for the second and third quarter, investors may want to watch for a fourth quarter disappointment. Across the larger retail sector, investors should watch for collateral damage to weaker players on a developing price war.

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