Wal-Mart Stores Inc. is the largest retailer in the world. They operate in the US and International market. Even if they did not have an international segment, they would be exposed to fluctuations in international exchange rates. More and more Wal-Mart is buying there products internationally. Their strategy as low price supplier forces them to buy products from countries that have a lower cost structure. The following is an extract from the management discussion of Annual report of 2003:
“Wal-Mart is in the business of serving customers. In the United States, our operations are centered on operating retail stores and membership warehouse clubs. Internationally, our operations are centered on retail stores, warehouse clubs and restaurants. We have built our business by offering our customers quality merchandise at low prices.”
It is important to note that Wal-Mart is offering quality merchandise, not the highest quality, at the low prices, not the lowest prices. It is interesting to know that often the larger quantity packages offered by Wal-Mart are more expensive (per item) than the lower quantity packages. In other stores that is generally not the case, but consumers are generally unaware of this fact and think it is cheaper to buy lager quantity packages.
Because of Wal-Marts strategy, offering our customers quality merchandise at low prices, it is essential for Wal-Mart to control their cost. In the international market that means that Wal-Mart need to be aware of the foreign exchange rate exposure. As mentioned earlier they are exposed at the buying of goods in the international market, but also at selling in the international market. In Appendix 1 there is an overview of the sales of Wal-Mart per segment. It is clear that their International sales are the fasted growing of all the segments in the last 4 years. While the total percentage of sales stays at about 17% of the total sales. Since 1999 the International segment has grown 2.5 times in square foot (Appendix 2). All of this indicates that the foreign exchange volatility is very important to Wal-Mart Stores Inc. If we combine this with the historical interbank exchange rates (Appendix 3) we understand the challenge of Wal-Mart. The annual report does not report where Wal-Mart buys their products, neither does it reveal if they take any measures to protect itself from currency fluctuations at the buying site.
An additional challenge for Wal-mart is that management also expects downward pressure on our gross margins as food sales continue to increase as a percentage of total Company sales both domestically and internationally. This trend results from the Company’s program to convert many of our Wal-Mart discount stores to Supercenters, which have full-line food departments, the opening of additional Supercenters and the opening of additional Neighborhood Markets all of which result in increases in food sales as a percentage of our total net sales. Food products generally carry lower margins than general merchandise2. This is a strategic decision with consequences for the cost control. If the margins get slimmer it is getting more important to control your cost and diminish fluctuations.
Wal-Mart is subject to different forms of transaction exposure. These are but not limited to:
Purchasing or selling goods internationally
Borrowing money to build stores (internationally)
Acquisition of foreign companies
Although the fluctuations in currency exchange market has positively affected the international sales segment by an aggregate of $47 million in the year 2003 Wal-Mart want to diminish these fluctuations. Because in the fiscal year 2002 foreign currency exchange rates accounted for a negative aggregate of $1.1 billion. The weakening of the US$ against the United Kingdom pound and Canadian $ are the main contributors to this effect.
Wal-Mart minimizes exposure to the risk of devaluation of foreign currencies by operating in local currencies and through buying forward currency contracts, where feasible, for certain known funding requirements. The also use derivative financial instruments for purposes to reduce their exposure to fluctuations in foreign currencies and to minimize the risk and cost associated with financial and global operating activities. Generally, the contract terms of hedge instruments closely mirror those of the item being hedged, providing a high degree of risk reduction and correlation. Contracts that are highly effective at meeting the risk reduction and correlation criteria are recorded using hedge accounting.
Wal-mart routinely enters into forward currency exchange contracts in the regular course of business to manage their exposure against foreign currency fluctuations on cross-border purchases of inventory. These contracts are generally for durations of six months or less. At January 31, 2003 and 2002, they held contracts to purchase and sell various currencies with notional amounts of $185 million and $117 million, respectively, and net fair values of less than $1 million at either fiscal year. The fair values of the currency swap agreements are recorded in the consolidated balance sheets within the line “other assets and deferred charges.” (See Appendix 4). The consolidated balance sheet shows an increase of $1.444 million in fair value currency swap agreements. This indicates that Wal-Mart is increasing their protection in relation to the increase of international sales. They might also be able to more accurate determine their need in foreign currency at any given time.
Wal-Mart is also vulnerable to foreign currency translation. Because they operate in many countries they have to “translate” the foreign currency into US$ for reporting purposes. The assets and liabilities of all foreign subsidiaries are translated at current exchange rates. Related translation adjustments are recorded as a component of other accumulated comprehensive income (see Appendix 5). The ineffective portion of an instrument’s change in fair value will be immediately recognized in earnings.
On the same note changes in Wal-Mart’s the International segment goodwill are the result of foreign currency exchange rate fluctuations and the addition of $197 million of goodwill resulting from the company’s Amigo acquisition. This means that foreign currency exchange rate fluctuations account for $760 million 2003 (see Appendix 6).
Besides income from sales and cost from COGS and investment Internationally Wal-Mart also has income from their suppliers. The most common of which are as follows:
Warehousing allowances – allowances provided by suppliers to compensate the Company for distributing their product through our distribution systems which are more efficient than most other available supply chains. These allowances are reflected in cost of sales when earned.
Volume discounts – certain suppliers provide incentives for purchasing certain volumes of merchandise. These funds are recognized as a reduction of cost of sales at the time the incentive target is earned.
Other reimbursements and promotional allowances – suppliers may provide funds for specific programs including markdown protection, margin protection, new product lines, special promotions, specific advertising and other specified programs. These funds are recognized at the time the program occurs and the funds are earned.
At January 31, 2003 and 2002, the Company had $286 million and $279 million respectively, in accounts receivable associated with supplier funded programs. Further, the Company had $185 million and $178 million in unearned revenue included in accrued liabilities for unearned vendor programs at January 31, 2003 and 2002, respectively.
If these suppliers are international suppliers and the products are used for the US market there is again transaction exposure. If they are supplying a local market (within the country) it might end up as translation exposure.
Wal-Mart uses derivative financial instruments for hedging and non-trading purposes to manage its exposure to interest and foreign exchange rates. Use of derivative financial instruments in hedging programs subjects Wal-Mart to certain risks, most noticeable as market and credit risks. Market risk represents the possibility that the value of the derivative instrument will change. In a hedging relationship, the change in the value of the derivative is offset to a great extent by the change in the value of the underlying hedged item. Credit risk related to derivatives represents the possibility that the counterparty will not fulfill the terms of the contract. Credit risk is monitored through established approval procedures, including setting concentration limits by counterparty, reviewing credit ratings and requiring collateral (generally cash) when appropriate. The majority of the Company’s transactions are with counterparties rated A or better by nationally recognized credit rating agencies.
It is clear from this analysis that Wal-Mart is exposed to many forms of foreign currency exposure. Within the organization it seems that they have done as much as possible to prevent changes in currencies to affect the financials of the organization. Although they have implemented many protective measures it is also clear that the will not be able to protect themselves for 100% as we could see in the 2003 annual report. We have also seen in the 2004 exchange rates that the US$ is weakening against all the currencies except the Mexican Pesos and Chinese Yuan. This means that there is a likelihood that the International segment will record more sales (in $), on the other hand the COGS might be higher as well (depending on the relationship between US / International suppliers).
I have omitted the cost associated with the different protective measures, because I was not able to derive these cost from the annual report or other information. The expansion in the international market will increase the vulnerability to changes in exchange rates, but on the other hand it might help Wal-Mart to increase the use of natural hedging, currency diversification, Multinational netting, leading and/or lagging. These tools are less costly than external protection.