A bottom feeding investor might be intrigued by an electronic games maker called Handheld Entertainment, a San Francisco-based company that's trading at about a third of its 52-week high of $7.78 a share. While the company lost $12 million last year, it competes in a business where one big hit can turn things around.
But there's another complication. Handheld Entertainment got 94% of its $3.8 million in sales through Wal-Mart, a dependency that it puts it at the mercy of the retail behemoth's decisions on shelf space and promotional efforts. And investors tend to frown on companies with too many eggs in one shopping basket--less diversification means more risk.
Selling a big chunk of your wares through Wal-Mart's enormous distribution system can be a boon if the company likes what you have, but it also has the market power to inflict a lot of damage by shifting your shelf space or dropping you altogether.
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"Wal-Mart can be your best customer and your most difficult one at once," says Walter Todd, a money manager at Greenwood Capital Management. "There's kind of a constant push and pull."
Business leaders, politicians and academics have debated the "Wal-Mart effect" on the U.S. economy for several years now. Mostly, they've been locked into the usual topics of low prices versus low wages, environmental concerns and discrimination toward workers. It's been enough to spur the Wal-Mart PR machine to work overtime trying to soften the company's image.
But other big pistons in the economic machine--institutional stock traders--are now basing more decisions on a different type of Wal-Mart effect. That is, measuring risk in consumer staple companies like Procter & Gamble and PepsiCo, in part, on how dependent they are on Wal-Mart to generate sales. Just as minimal diversification makes any investment portfolio more risky, a maker of laundry detergent, cosmetics or soft drinks could be flirting with danger when a high percentage of sales are pushed through a single retailer.
"Investors like to have better visibility into a company's sales and into supply chains," says Kevin O'Brien, chief executive of Revere Data, a financial information provider that tracks the percentage of sales that hundreds of companies generate through Wal-Mart. Revere specializes in analyzing corporate influence through a company's business relationships.
Just ask Newell Rubbermaid, the maker of cleaning products and other consumer staples that hit a slump in the late 1990s, about Wal-Mart's market power. With the company's goods not moving at a pace that satisfied Wal-Mart, it lost prime eye-levelshelf space. Newell Rubbermaid shares dropped from $50 to $20 between 1999 and 2001 before steadying. They're now back to $30, but haven't been close to their highs of eight years ago.
To measure the "Wal-Mart effect" on profits across different industries, Forbes analyzed information compiled by Revere to compare the percentage of sales that various firms generated through Wal-Mart in fiscal 2006to the gross margins those firms produced during the same period. The survey covered 333 companies in six industry sectors that sell heavily to discounters and other retailers--apparel & accessories, consumer games & electronics, household accessories, food & beverage, personal care and leisure goods.
On balance, firms that derive less than 10% of its sales through Wal-Mart averaged 39.1%in gross margin, or the percentage of profit realized before items like fixed costs and interest expense are considered. For those falling between 10% and 20%, gross margin falls to 36.2%. Above 20%, and margin dips a little bit more, to 35.4%.
The trend is most pronounced in the apparel & accessories category, where average gross margin drops from 48.7% for companies generating less than 10% of its sales through Wal-Mart, to 28.7% for those selling 20%or more. Food & beverage also shows a big disparity, where the same breakdown shows average gross margins dropping from 39% to 22%.
In all, only 25 of 333 companies managed to beat its sector gross margin average while generating at least 10% of their revenue through Wal-Mart. Only seven that sold over 20%there did it. And the numbers show that company size has little to do with Wal-Mart dependency, at least once you get past the top handful.
The 10 companies that sell through Wal-Mart in the highest percentages, a list that includes apparel maker Jaclyn and personal care company CCA Industries, average a relatively paltry $107 million in market cap (CCA is the only top-10 member whose gross margin beats its sector average).
But past the top 10, companies that generate at least 10% of their sales through Wal-Mart carry an average market cap of $5.9 billion, more than the $4.9 billion average of those firms that sell less than 10%there.
While Wal-Martsqueezes margins of suppliers of all sizes, it's still true that smaller companies tend to feel a tighter pinch. For example, beverage company Cott Corporation, even with a market cap in excess of $1.2 billion, doesn't have the brand strength of Coca-Cola or PepsiCo, whose products are in more demand at supermarkets, convenience stores and other outlets. So Cott turns to Wal-Mart for 38% of its sales, compared to less than 10% for the two beverage titans.
Theresult? Cott's gross margin of 12.4% last year was about a third the industry average, while Coke and Pepsi both registered over 50%.
Buteven blue chips aren't exempt from investors' scrutiny. A double-digit percentage of sales through Wal-Mart or any other single retailer always raises a red flag.
"I wouldn't not own a company just for that reason, but if I could choose between two companies that were basically equivalent, I'd choose the one that sells less through Wal-Mart,"Todd says.