Stocks that Wal-Mart holds hostage

By Forbes.com

A bottom-feeding investor might be intrigued by an electronic-games maker called Handheld Entertainment, a San Francisco company that's trading near 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 (ZVUE, news, msgs) got 94% of its $3.8 million in sales through Wal-Mart Stores (WMT, news, msgs), 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 because 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 Wal-Mart also has the market power to inflict a lot of damage by shifting your shelf space or dropping you altogether.

The 'Wal-Mart effect'

"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 such as Procter & Gamble (PG, news, msgs) and PepsiCo (PEP, news, msgs), 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, the 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 (NWL, news, msgs), a maker of cleaning products and other consumer staples, about Wal-Mart's market power. With the company's goods not moving at a pace that satisfied Wal-Mart, it lost prime eye-level shelf space in the late 1990s. 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.

Double-digit sales a red flag

To measure the Wal-Mart effect on profits across different industries, Forbes.com analyzed information compiled by Revere to compare the percentage of sales that various firms generated through Wal-Mart in fiscal 2006 to 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 and accessories, consumer games and electronics, food and beverage, household accessories, personal care and leisure goods.

On balance, firms that derive less than 10% of their sales through Wal-Mart averaged 39.1% in gross margin, the percentage of profit realized before items such as fixed costs and interest expense are considered. For those falling between 10% and 20%, gross margin was 36.2%. Above 20%, and margin dipped a little bit more, to 35.4%.

• Video: Wal-Mart wins over Mexican village

The trend is most pronounced in the apparel-and-accessories category, where average gross margin drops from 48.7% for companies generating less than 10% of sales through Wal-Mart to 28.7% for those selling 20% or more. Food and 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 their sector gross-margin average while generating at least 10% of their revenue through Wal-Mart. Only seven that sold more than 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 (JLN, news, msgs) and personal-care company CCA Industries (CAW, news, msgs), 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-Mart squeezes margins of suppliers of all sizes, it's still true that smaller companies tend to feel a tighter pinch. For example, beverage company COTT (COT, news, msgs), even with a market cap in excess of $1.2 billion, doesn't have the brand strength of Coca-Cola (KO, news, msgs) or PepsiCo, whose products are in more demand at supermarkets, convenience stores and other outlets.

So Cott, whose primary business is producing and distributing company-brand carbonated soft drinks, turns to Wal-Mart for 38% of its sales, compared with less than 10% for the two beverage titans. The result? Cott's gross margin of 12.4% last year was about a third the industry average, while Coke and Pepsi both registered more than 50%.

But even 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," says Todd, of Greenwood Capital Management.

This article was reported and written by Tom Van Riper for Forbes.com.