This US retailer is about to profit from huge investment

The problem for lots of businesses nowadays is they need massive scale for this to work. This is partly because robotics are expensive and you need millions, if not billions, in the bank to afford such a project. On top of this, the investment only makes sense once economies of scale kick in. A fully automated warehouse serving one customer would be a massive loss-maker, but if it could serve 100,000 customers it would soon have paid off the initial investment.

It is for this reason that the world’s largest retailer, Walmart (US:WMT), could be due a re-rating. The company has been ramping up investment in both its warehouses and AI platforms as it looks to take a step up in profitability.

Broker Jefferies outlines the size of this opportunity in a deep dive called "AI & Automation Opportunity”. It forecasts that innovations in automated distribution, advertising, shrink reduction and freight optimisation will generate more than $20bn of incremental operating profit by 2029. For reference, Walmart made $27bn of operating profit last year.

Walmart has been investing heavily to build out its e-commerce offering. Last year, capital expenditure rose to $20.6bn, up from $16.9bn in 2022 and $13.1bn in 2021. A large chunk of this went into building automated warehouses. It is a big up-front cost but – assuming the technology works as expected – it should enable the company to grow without having to increase headcount in the medium term. 

In fact, Walmart is planning to add $130bn of retail sales over the next five years without meaningfully increasing its staff base. Jefferies believes this will generate around $7bn of savings. However, it expects Walmart to invest a lot of this back into its workforce via training, benefits and higher salaries, based on the fact the retailer invested $5bn into its workforce between 2015 and 2021.

It is not just in the supply chain that Walmart is innovating. It has also partnered with Microsoft (US:MSFT) and OpenAI to use generative AI to improve the customer sales experience. It's in a good position to do this: with around 240mn unique weekly customers across 19 different countries, Walmart has access to one of the largest retail datasets in the world.

On the app, website or by email, it can use this data to suggest products to customers. Walmart has already noticed that marketing email open rates are higher than ever before. This keeps customers shopping at Walmart and not looking elsewhere.

High-margin advertising 

This abundance of data has also allowed Walmart to create a profitable advertising business. Ever since Apple (US:AAPL) gave users the option to stop apps tracking them around the internet, large retailers such as Walmart and Amazon (US:AMZN) have been investing heavily in their own ad products.

These companies don’t need to follow customers' across the web; they already know their buying habits inside out. Plus, if someone is on the Walmart website they are clearly intending to spend. A well-placed advert could sway their decision, meaning retailers can charge a lot for the ad space. 

Last year, Walmart’s advertising revenue grew 28 per cent to $3.4bn, and it was accelerating in the last quarter, with year-on-year growth of 33 per cent. In the context of $648bn of total revenue this might not sound like a lot, but advertising is high-margin. Walmart doesn’t split it out, but advertising operating margins usually reach around 70 to 80 per cent, compared with roughly 4 per cent for the business as a whole. This suggests that advertising already makes up around 10 per cent of the total operating profit.

To bulk up its advertising business, Walmart recently acquired smart TV company Vizio for $2.3bn. Vizio has 18mn active accounts, which gives Walmart a lot of viewing data and another medium through which to reach its customers. Jefferies has forecast that, with Vizio, Walmart could grow its advertising business to $10bn of revenue by 2029, which would equate to around $7.5bn in operating profit.

The other area of high-margin growth relates to its US 'marketplace' product. Like Amazon, this provides a space for third-party buyers and sellers to connect, and Walmart uses its fulfilment network to deliver the packages. The marketplace division grew by 45 per cent last year, with more than a third of the packages delivered by Walmart.

All this spending isn’t just a bet on the future; Walmart is already seeing returns on its investment. In the three months to January, revenue rose 4.9 per cent year on year to $172bn, which was a little ahead of the broker consensus of $170.8bn. This growth looks more impressive when compared with Home Depot (US:HD), which reported on the same day and saw revenue fall by 2.9 per cent.  

Despite inflation, Walmart also managed to increase its gross margin by 39 basis points to 23.3 per cent in the quarter. For context, gross margins at Tesco (TSCO) and Sainsbury’s (SRBY) hover at around 7 per cent.

Walmart managed this through a combination of price rises and better inventory management, which meant it was left with fewer products it needed to sell at a discount. Inventory management is another area where big data helps. Walmart’s AI will automatically spot when products are selling well and then shift them there. For example, if a toy is proving particularly popular on the east coast it can be instantly shipped from the west to meet that demand. This is only possible for a retailer with such massive scale.

Scale creates a moat 

Scale has other implications, of course. It is unlikely that Walmart will see revenue growth much beyond the wider US economy, for example. Walmart has an international business, but it still makes two-thirds of its revenue from domestic customers.

Correspondingly, analysts only expect its sales to increase by 8 per cent between now and 2026. Walmart's potential stems from its margin expansion, though, and profit before tax is due to increase by 14.4 per cent in the same period. 

Walmart is trading on a forward price/earnings ratio of 25, which isn’t cheap, especially for a company so mature. But while there is clear upside to all its recent investment, there is limited downside. The huge capital investment creates a moat around the business, and Walmart has enough cash to keep investing in the coming years, meaning the only realistic competition can come from Amazon.

Meanwhile, the fact that Walmart is a value retailer limits the potential damage from a US recession. In fact, Jefferies predicts that a slowdown could act as a tailwind. “We believe Walmart US will continue to gain share, as the consumer wallet is tightened, student loan payments resume, trade-down continues, private label penetration grows, and consumer spending habits shift from wants to needs,” it concluded.

As machines become more expensive and more powerful, returns are accumulating in the hands of the few companies that can afford the up-front costs. Meanwhile, the past few years have shown it is rarely a good idea to bet against the strength of the US consumer. Against this backdrop, it seems an especially bad idea to bet against its largest retailer.