Earnings Call Transcript - WMT Q2 2023

Operator, Operator

Greetings. Welcome to the Walmart Fiscal Year 2023 Second Quarter Earnings Call. The question-and-answer session will follow the formal presentation. Operator provided instructions. Please note this conference is being recorded. At this time, I’ll turn the conference over to Dan Binder, Senior Vice President, Investor Relations. Dan, you may begin.

Dan Binder, Senior Vice President, Investor Relations

Thank you, Rob. Good morning and welcome to Walmart’s second quarter fiscal 2023 earnings call. I am joined by members of our executive team, including Doug McMillon, CEO; John David Rainey, Executive Vice President and Chief Financial Officer; John Furner, President and CEO of Walmart U.S.; Judith McKenna, President and CEO of Walmart International; and Kath McLay, President and CEO of Sam’s Club. In a few moments, Doug and John David will provide you an update on the business and discuss second quarter results. That will be followed by our question-and-answer session. Before I turn the call over to Doug, let me remind you that today’s call is being recorded and will include forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially from these statements. These risks and uncertainties include, but are not limited to, the factors identified in our filings with the SEC. Please review our press release and accompanying slide presentation for a cautionary statement regarding forward-looking statements as well as our entire Safe Harbor statement and non-GAAP reconciliations on our website at stock.walmart.com. It’s now my pleasure to turn the call over to Doug McMillon.

Doug McMillon, Chief Executive Officer

Good morning and thanks for joining us. A few weeks ago, we updated you on our expectations for how we would perform in Q2 and for the year. The second quarter finished stronger than we had anticipated and John David will touch on that in a moment and provide more detail for the back half of the year. Our sales were well ahead of plan, with inflation lifting our average transaction size, but we know that the amount and persistence of inflation is negatively affecting many families. From the U.S. to Mexico to Canada to Chile, they are prioritizing how they spend their money. We are pleased to see more families from a variety of income levels choose us as they look for value. Our purpose is to save people money and help them live better and that’s especially important right now. After the first quarter, we shared how the environment had changed. The cost of food and fuel, a heavier mix of sales in food and consumables, and excess inventory in general merchandise categories were among the most challenging items for us at the time. As we move through Q2, food inflation continued to tick up and we continued to see a heavier mix of sales in food and consumables in many of our markets and that put pressure on margins overall. Food comps in the U.S. were up mid-teens for the quarter, with units in food slightly negative and about flat exiting the quarter even with double-digit inflation. Another weight on margins has been the number of markdowns we have taken. Starting back in March, we knew we needed to act quickly and aggressively in some categories and we have. We have made good progress to reduce inventory levels where we focused and taken markdowns. The aggressive approach we took to move through apparel in particular put financial pressure on us, but it helped relieve pressure on our stores and through our supply chain. We are making good progress to reduce costs. We have reduced the number of shipping containers in our system, for example, by more than half from the Q1 level and are now much closer to our historical averages. We are also managing pricing to reflect our fully landed costs. The merchants are adjusting by category to reflect where we expect demand to be. We had our U.S. store manager meeting last week and amongst other topics, we shared examples of items where we are holding prices down or rolling them back. Those tend to be opening price point, private brand, food and consumables items. We want to help families put meals on the table with great value in our other private brands to relieve the pressure they are feeling. The quality, value and convenience we offer, makes Walmart a smart choice and we are seeing more middle and higher income shoppers choose us. As I have been in U.S. stores recently, I am pleased how we have executed back-to-school. As we finish it off in some markets, we have transitioned to back to college in the appropriate stores with items like mini refrigerators, floor-length mirrors and futons. In July, I got to visit our associates in India. After visits to Flipkart, Myntra and PhonePe, a Flipkart fulfillment center and a Kirana to see how they are using PhonePe, I left even more excited about what’s happening in these businesses and what’s to come. Having visited several of our international markets this year, I am pleased by how connected we are now and how so much of what we are building is common across markets as we scale marketplace businesses and fulfillment advertising and financial services and take steps to make a bigger difference in healthcare. As I look ahead, I expect a strong finish to the back-to-school season and we will quickly transition to the holidays. Our fall and holiday products look great. There is a lot of newness and we have got a strong position in opening price points across categories. From Halloween to Christmas to Flipkart’s Big Billion Days, we will be ready. We will have a cleaner inventory position and we will have a strong seasonal presence. We expect inflation to continue to influence the choices that families make and we are adjusting to that reality so we can help them more. Regardless of the inflation level and as we work through the places we have too much inventory, we continue to make progress on our strategy. We are becoming more digital, even more relevant as an omnichannel retailer and the related businesses, like fulfillment and advertising, continue to grow. We are building a different business and we are making progress. Let’s move on to our operating segments. I’ll start with Walmart U.S. The strong comps we see in food and consumables are leading to market share gains. Pickup and delivery are strong. Growth is improving on Walmart.com, including the marketplace and more people are choosing to be a Walmart+ member or step up to in-home. Walmart+ is an important component of our plan and we announced the addition of a streaming benefit. Walmart+ members will receive a Paramount+ subscription at no additional cost as part of their Walmart+ membership in September. The premium streaming service offers a broad content offering with original series, movies, family shows and live sports. We are excited about the coming launch and we know our members will be, too. Beyond membership, the team is also working on getting items to customers faster, while lowering the cost of delivery through a significant increase in the number of orders fulfilled by stores. We have increased this volume by nearly 40% from a year ago. Speed matters, whether it’s how quickly we get items to customers or how quickly we scale new businesses. Our white label delivery platform service, Walmart Go Local, will celebrate its 1 year anniversary later this month. Powered by our Spark Driver platform, I am excited about the growth I have seen so far and the expectations looking ahead. We passed 1 million deliveries so far with Go Local. We expect to have about 5,000 pickup locations by year end and client satisfaction scores are strong. We continue to sign up larger scale customers and we are making strides on the bigger unlock, which are small and medium-sized businesses. Our technology and expertise will help so many of these businesses grow, while contributing to our operating margins over time. Advertising is also performing well. In Walmart U.S., the Walmart Connect team continues to deliver more value to the suppliers and sellers who advertise with us. Improvements to search and our large first-party shopper data have led to performance improvements for our advertisers, both year-over-year and sequentially. We have seen the number of active advertisers investing with us increase 121% over last year. Even more encouraging, these improvements have supported the overall site experience for our customers by helping them find the right products or discover new ones that are most relevant to them. As you have heard us say before, advertising is a global priority for us. We continue to see strong growth in markets outside the U.S., like India and Mexico. Turning to Sam’s Club in the U.S., comp sales were strong again for Q2, up 10%, marking the tenth consecutive quarter of double-digit comp growth. Similar to Walmart, gross profit was pressured for the quarter on higher than normal markdown activity to clear through excess inventory. We will continue to make progress as we move through Q3 and we will be in good shape as we enter the holiday season. We like what we see in terms of membership. Total counts are up about 9% over last year and the penetration of Plus members continues to climb. Moving on to Walmart International, where we performed well again in Q2 with sales up nearly 10%, including double-digit comps in the three largest markets of Mexico, Canada and China. We are also accelerating our digital businesses, including strong e-commerce growth over the last 2 years. Mexico is up 31%; Canada, 32%; and China 152%. We see this growth even as customers choose to do more in-person shopping. It really shows the power of operating across multiple channels. Like the U.S., we see the effects of inflation come through in how people are shopping. In Mexico, we saw all formats perform well and Bodega was especially strong with comps above the overall Walmex average. We widened our price gaps for Bodega by 140 basis points in Q2 and we are seeing more customers shopping this format. While inflation remains high, most of our markets are growing comps ahead of inflation. I am proud that we are helping families access the things they need at more affordable prices. I will close today by thanking our associates for all they do everyday to support our customers and members. I’d also like to welcome John David for his first earnings call with us. And with that, I will turn it over to him.

John David Rainey, Executive Vice President and Chief Financial Officer

Thanks, Doug. I’d like to start by thanking our customers, associates and partners for helping us deliver another strong sales quarter. We are moving a lot of volume through our business and I am proud of how our associate team has responded and serving customers as we manage through this unique period. We delivered strong top line growth with total constant currency revenue up more than 9% in the second quarter. Sales were strong across all segments, particularly in food and consumables. Customers are increasingly choosing Walmart to help them save money as they deal with broad inflationary pressures. As we navigate the current environment, we know that we are not immune to large macroeconomic shifts. We are facing similar cost pressures that others are seeing related to excess inventory, fuel prices and supply chain. But our business model is structurally sound and our market position is strong. As the year has progressed, we have seen more pronounced consumer shifts and trade-down activity. As an example, instead of deli meats at higher price points, customers are increasing purchases of hotdogs as well as canned tuna or chicken. Private brand penetration has also inflected higher. And in food category, specifically the private brand growth rate doubled compared to Q1 levels. We will continue to manage pricing for customers in a way that preserves our price gaps and allows us to earn market share profitably. We have been very focused on managing controllable costs and consequently achieved expense leverage across all three segments in Q2, even though we haven’t fully lapped the wage investments implemented last year. During the quarter, we also made progress reducing inventory, managing prices to reflect certain supply chain costs and inflation and reducing storage costs associated with the backlog of shipping containers. We are encouraged by the initial steps taken by some suppliers to help us reduce product acquisition costs. We have taken similar steps to manage our support and overhead cost too and we are achieving significant savings in procurement of goods not for resale. In our stores and fulfillment and distribution centers, we have seen labor productivity metrics improve. We are finding efficiencies and reducing expenses, while still focusing on operational excellence. I want to spend a moment discussing inventory. As a backdrop, the shifts that we have seen in consumer behavior through the pandemic shifting from in-store to online, along with big swings in the purchase of goods versus services and then the reversion back to pre-pandemic norms have been sharp and difficult to predict. These trends have been exacerbated by inflationary pressure on the consumer that many of us have not experienced in our lifetime, the effect of which has recently changed consumption patterns in certain categories for us, notably general merchandise. The result of all of this put pressure on our inventory levels that peaked in the last quarter. Importantly, the team has a deep understanding of our inventory levels in content and have made a lot of progress during the last quarter. In-stock levels have improved about 250 basis points since Q1 in our grocery business alone, despite the heavy sales volumes we are experiencing. We also made progress selling through excess inventory, especially in hardline categories. At the end of Q2, Walmart U.S. inventory growth was 26% versus last year, reflecting over 750 basis points of improvement from Q1 levels. Notably, about 40% of the year-over-year increase relates to inflation. General merchandise inventory growth rates are down more than 15 percentage points from Q1, but still with more work to do. We have cleared most summer seasonal inventory, but we are still focused on reducing exposure to other areas such as electronics, home and sporting goods. We have also canceled billions of dollars in orders to help align inventory levels with expected demand. We estimate that only about 15% of our total inventory growth in Q2 is still above optimal levels and our actions in Q3 will allow us to make significant progress toward rationalizing absolute levels and mix, which will enable our stores to be well positioned ahead of the holiday season. Despite the short-term challenges we are facing this year, we continue to advance our flywheel strategy and diversify our income streams. For example, the global advertising business grew nearly 30% in Q2, led by Walmart Connect and Flipkart as new advertisers turn to Walmart to deepen relationships with customers. We now have over 240 million items in our U.S. e-commerce assortment and our marketplace seller count has increased about 60% year-over-year. We continue to sign on more customers to our data ventures offering and the number of Walmart+ memberships continues to grow. We are also excited about the build out of automation and technology throughout our business and how it will continue to help drive greater efficiency. Through my first couple of months here, I have been able to get out and visit our stores and see our distribution and fulfillment centers and witness the supply chain automation and technology that we are putting in our stores and centers. One example is the Vizpick technology that we have rolled out to our associates across U.S. stores. This tool uses augmented reality to speed the inventory management process, enabling associates to get needed product from the backroom to the sales floor more efficiently. This not only saves associate time, but also helps avoid missing sales through side counter out of stocks. It’s a win-win. In summary, our business is resilient. And with the omni capabilities we’ve built, we are better positioned now than we were in prior periods of economic softness. Now, let’s get to some additional Q2 financial details. As mentioned previously, each of our segments delivered strong sales growth. Walmart U.S. comp sales accelerated to 6.5% growth, reflecting strong grocery sales at a higher average ticket size. International constant currency sales were up 9.9% with strength in Mexico, Canada and China, while Sam’s Club U.S. delivered comps of 10%, excluding fuel and tobacco. Consolidated gross margin rate decreased 132 basis points, reflecting increased markdowns and unfavorable mix shifts in our U.S. businesses. Sam’s Club gross profit was also negatively affected by a LIFO charge due to higher inflation. On the expense side, selling, general and administrative expenses leveraged 45 basis points, helped by higher sales partially offset by the U.S. wage investments implemented last year. Operating income decreased 6.8% and adjusted EPS was $1.77. Two discrete items positively affected our results. Operating income benefited from a favorable insurance settlement of $173 million during the quarter. Adjusted EPS also benefited from this as well as a $182 million special dividend from one of our equity investments. Operating cash flow was $9.2 billion, reflecting lower operating income, higher inventory amounts due in part to inflation and the timing of certain payments. During the quarter, we returned $4.9 billion to shareholders through dividend and share repurchase. Through Q2, we are ahead of pace on our original share repurchase plan for this year and now expect to repurchase $10 billion to $11 billion in shares for fiscal year 2023. Now, let’s discuss segment results. Walmart U.S. comp sales momentum continued with growth excluding fuel of 11.7% on a 2-year stack. Food sales were especially strong with mid-teens growth while general merchandise sales were soft, particularly in electronics, apparel and home. Transactions increased 1%, while average ticket increased 5.5%. We were pleased to see e-commerce sales growth improve sequentially, up 12% year-over-year in Q2 and 18% on a 2-year stack. SG&A expenses leveraged 21 basis points, reflecting higher sales and lower COVID costs, partially offset by the wage investments. The team did a nice job pivoting the expense structure, so the scheduling challenges from Q1 did not repeat. Gross margin pressure led to a decline in operating income of about 7%. International had another really good quarter. Sales were strong, up 9.9% in constant currency. Currency headwinds negatively affected reported sales results by about $1 billion. Each of our major markets delivered positive comp sales, with Mexico and China leading the way. E-commerce sales on a constant currency basis grew 15% on top of strong gains last year. Comp sales in Mexico increased nearly 11%, with strong growth in stores as well as e-commerce sales, which grew 18%. The team is doing a good job reinforcing our price message and positioning as customers manage through this inflationary period. In China, comp sales were up more than 14%, with strong growth in e-commerce sales, which increased 77% in the quarter and more than 150% on a 2-year stack. E-commerce penetration continues to climb in both our Sam’s Clubs and hypermarket stores as customers increasingly choose omni solutions to meet their shopping needs. Canada comp sales increased more than 10% even as higher levels of inflation are starting to pressure consumer spending in discretionary and general merchandise categories. Flipkart continues to meet our expectations and the team is gearing up for Big Billion Days. I traveled to India last month and was impressed by how the Flipkart and PhonePe teams are innovating for the customer and driving growth. PhonePe continued to see strong growth, with annualized TPV of over $830 billion, reaching a record level of monthly transactions of about $3.1 billion. International operating income in constant currency increased more than 28%, partially attributable to the previously mentioned insurance recovery for prior operational disruptions in Chile. Sam’s Club had another strong sales quarter with comp sales up 10%, excluding fuel and tobacco, an increase of more than 20% on a 2-year stack. Transactions increased 9.8%. E-commerce sales grew 25%, with strong contributions from both curbside and ship-to-home orders. Membership income was up nearly 9%, with another record high quarter in overall member counts and continued growth in Plus member penetration. Sam’s added more new members in Q2 than any other quarter in recent years, benefiting from membership campaigns. Sam’s leveraged expenses 131 basis points, including fuel and 72 basis points excluding fuel, due primarily to higher sales and lower COVID costs. But gross margins were down as elevated markdowns, supply chain and fulfillment cost and a 70 basis point inflation-related LIFO charge pressured profitability. As a result, operating income declined about 35%. Now, let’s turn to guidance. With the updated financial guidance we released last month, we outlined the pressures that led us to take a more conservative outlook for the current year profitability. Let me take a minute to provide you with more detail. When we provided guidance 3 months ago, we didn’t expect food and fuel inflation to accelerate to the levels that we experienced in Q2. In fact, Walmart U.S. food inflation was up double-digits year-over-year and we saw a nearly 400 basis points step up as the quarter progressed compared to levels at the end of Q1. The rising cost for essential items and customers’ reprioritization spending led to significant mix shifts in our business. Grocery sales mix increased nearly 300 basis points, whereas general merchandise sales mix decreased more than 350 basis points. This resulted in additional general merchandise markdowns in our U.S. business, particularly in apparel at a time when inventory clearance was already higher than expected in the industry. Higher fuel prices also pressured our supply chain expense. We finished the quarter on a strong note, however, and ahead of our updated Q2 guidance provided last month, and the Q3 back-to-school season is off to a solid start. Contributing factors to the better performance included strong sales at the end of the month with good flow-through to the bottom line and lower-than-expected supply chain cost. We’re taking additional pricing actions in Q3 to improve inventory levels in the back half of the year, and we built in more conservative category mix assumptions within our guidance. Our sales and profit view reflects trends we’ve seen year-to-date as well as the uncertainty around inflation and consumer spending in the coming quarters. We’ve updated our fiscal year ‘23 guidance to reflect the better Q2 results versus the guidance we provided in July. We continue to believe the sales and profit guidance we provided at the time for the back half of the year appropriately reflects elevated uncertainty in this environment and is our best view of expected performance. For Q3, we expect net sales growth of about 5%, including comp sales growth of about 3% for Walmart U.S. We’re expecting operating income to decline 8% to 10% and adjusted EPS to decline 9% to 11%. For fiscal year ‘23, we expect net sales growth of about 4.5%, including comp sales growth of about 4% for Walmart U.S. We expect adjusted operating income and EPS to decline 9% to 11%. Excluding the effect of divestitures, this would translate into net sales growth of 5.5% and a decline in adjusted operating income and EPS of 8% to 10%. Before I close, I’d like to share my perspective as someone that is new to Walmart and meeting many of you for the first time. I’m excited to join the company at such an opportunistic and transformational time. Certainly, retail broadly is being pressured right now, but that shouldn’t detract from the incredible opportunity that we have in front of us. It starts with our mission of helping people save money so they can live better. We do that every day at a scale that is unmatched by helping people be able to buy the things that they want and they need. This mission permeates our culture in everything that we do. I’ve joined an exceptional leadership team. Their history of operational excellence, their strategy, the drive to win is simply something that I wanted to be a part of. And you combine that with the resources we have and the investments we’re making in things like supply chain automation, improving our e-commerce capabilities and diversifying our portfolio with higher-margin products and services like data and advertising that will result in more durable earnings streams as they scale. We have the potential to not only be relevant in the next chapter of retail, but help define it. And when we execute on these things, we have the ability to appreciably increase our shareholder value over time. I believe that some of the best days of Walmart are in front of us. I look forward to working with you, and now we’d be happy to take any of your questions. Thank you.

Operator, Operator

Thank you. Operator provided instructions. And our first question is from the line of Bob Drbul with Guggenheim Securities. Please go ahead with your question.

Bob Drbul, Analyst, Guggenheim Securities

Good morning. And John David, welcome. Congratulations. Maybe two quick questions, if I could. The first one, I think, Doug, you mentioned that sort of middle and higher income shoppers are choosing Walmart. Just wondering if you can elaborate some more on the trade into Walmart that is allowing you to take market share in grocery. And the second question is just wondering if you could give us a little bit more flavor on what you’re seeing, what you saw sort of with sales late in the quarter and what you’re really seeing so far early Q3? Thanks.

John David Rainey, Executive Vice President and Chief Financial Officer

Thank you.

Doug McMillon, Chief Executive Officer

Yes. Hi, Bob, this is Doug. I’ll kick it off and then ask John to comment. In Walmart U.S. business, we have seen mid- to higher income customers come to Walmart looking for value, as you would expect, food and consumables, in particular, are places where they are looking to save some money. That’s not a total surprise. I think the strength of it is encouraging. And then as it relates to the end of the quarter, there were several things going on. Fuel prices started to move a little bit. Back to school was strong. And then this income phenomenon that you pointed to also provided some strength to the last week or so of the last month of the quarter, which was a little different than the pattern that we had seen in the first 2 months of the quarter.

John David Rainey, Executive Vice President and Chief Financial Officer

Yes, Doug, it was a bit different than May and June, for sure, and it has led to the beginning of Q3 being stronger in places like back-to-school. Food and consumables continue their momentum. I think the big change in late Q2 and early Q3 was that traffic counts were a bit stronger than what we had seen earlier in the quarter.

Doug McMillon, Chief Executive Officer

We were laughing before the call started today about some of the anecdotal stuff that’s going on. It won’t surprise you that backpacks are strong, for example, but it does surprise us how strong men’s flannel is. And we’ve got a program that’s just under $12. I bought two of them personally, and it’s a great value. And at the same time, some of our clearance price points have gotten really low. We’re trying to work through what we would call season code two apparel, and we’ve got new stuff selling well. So it’s almost like you can point to different areas to kind of make the case for what you want the sales story to be.

Operator, Operator

Thank you. Our next question is from the line of Kate McShane with Goldman Sachs. Please proceed with your question.

Kate McShane, Analyst, Goldman Sachs

Hi, good morning. Thanks for taking our question. Our question is centered around markdowns. We are curious if the level of markdowns that you plan to take in Q3 will be at a similar level as what you did for Q2. And it sounds like inventory will be much cleaner by Q4, but it seems like there is still a lot of inventory in the industry and the consumer that might need to be motivated by promotions given the amount of inflation. How should we think about the markdown environment then in Q4 even in the context of cleaner inventory at Walmart?

Doug McMillon, Chief Executive Officer

Hi, Kate, this is Doug. Thanks for the question. I think what we should do is hear from all three segments as it relates to that. We’ve made progress. John, why don’t you go first, but let’s also hear from Kath and from Judith.

John Furner, President and CEO, Walmart U.S.

Good morning, Kate. From the end of Q1 to the beginning of Q2, there was some definite progress in inventory, about 750 basis points of improvement. We view Q2 as being most urgent to clear through the apparel and some seasonal items that we needed out of the way and sold before Q3 really began to arrive. We certainly made progress in apparel. There is more work to be done in inventory in general with a 25% increase and about 40% of that inflation. The remaining increase does two things. One, it helps us in terms of in-stock — we were out of stock last year in many places. So we have made improvements on in-stock. I think our results in many categories reflect improvements in availability in stores. But then there is some backlog that we continue to work through. At the end of Q1, we said this would take a couple of quarters to work through. I would just reiterate that that remains true. And we will continue to leave room to make sure that we manage our inventory levels well and head into a position in Q4 at the end of the year that we will be proud of.

Doug McMillon, Chief Executive Officer

I think the fact that we were so lean last year, combined with how much inflation impacted the number, has kind of been lost in the story a bit. It’s true that we’ve got too much inventory and that created markdown pressure, particularly in Walmart U.S. apparel. But when we look at the overall inventory, as John David has already commented today, it’s not like the vast majority of it is merchandise that we didn’t want. We just were turning goods a year ago and the year before that at such a high level that we needed that inventory just to fill side counters and to fill our features.

Kath McLay, President and CEO, Sam's Club

Yes, I’d really just say, if I look at our inventory position at the moment, for the last 2 years, as we talked about, we’ve had 10 quarters of double-digit comps. For the last 2 years, we’ve struggled to stay in front of having enough inventory. So we’re off a deflated base when you look at what our current position is. This year, then obviously we have the contraction with inflation. But what we’ve seen is that we’ve got really good quality inventory. We’re really happy with the seasonal sets we’ve got. Halloween looks fantastic; back to school, back to college has been good. Tailgating has been great. In our number this quarter, a portion of it has been markdowns and a portion of it is actually inventory reserve because we wanted to get in front of it and just make sure that we put aside the money for Q3 so that we can have a really strong Q3. So that’s how we’ve addressed markdowns in Q2.

Judith McKenna, President and CEO, Walmart International

For International, we saw some good progress on inventory quarter-on-quarter, some of that helped by the FX position and underlying improvements as well. I think, as I look at it, about 75% of our increase year-on-year is absolutely planned for. As you’ve heard, that leanness we had last year is really coming through. That leaves about 25% of it, which is some general merchandise categories in a couple of markets, specifically Chile and Canada. I’m very comfortable with the way those markets have dealt with that. And just as a reminder, for Chile, our quarter end is a month earlier than the enterprise quarter end, so we’re already seeing some of that clearance happening for that market.

Operator, Operator

The next question comes from the line of Peter Benedict with Baird. Please proceed with your question.

Peter Benedict, Analyst, Baird

Hi, good morning, guys. Thanks for taking the question. Just want to talk a little bit about grocery, the strength there, particularly in food. Can you talk about pricing, how you’re managing that? I know units, it looks like they were down for the quarter, but improving to, I guess, flattish as you exited the quarter. Just how are you thinking about pricing relative to units? What’s the promotional environment you’re seeing within grocery and just how the grocery strength is split in store versus online and curbside? Thank you.

John David Rainey, Executive Vice President and Chief Financial Officer

Hi, good morning, Peter. Let me take your question in parts. First, value is always top of mind when it comes to us and deciding how we want to serve customers. So we will always lean on value above other things. We try to go up on price as late as possible. We have been passing prices through when we see things like landed cost of goods going up; those have to be passed through. We’re managing our supply costs as well as we can. Units did strengthen throughout the quarter, particularly in July and late July. So seeing some positive units there was refreshing given how we had started the quarter. Fuel prices were coming down, which could have had some impact as well. In terms of the market, we’re focused on everyday low price. We have a strong rollback campaign across the store, including food, consumables and general merchandise. And generally, across the food categories, our availability improvements are visible in stores more consistently across categories. Last year we had pockets of stock issues; the only one we really faced in the second quarter in a big way was baby formula, which is now improving.

Doug McMillon, Chief Executive Officer

The unit story is important — the transaction count being up a little in this environment is also important to call out. The average basket was way up, but it’s great to see transactions grow in the Walmart U.S. business also.

Operator, Operator

Thank you. Our next question is from the line of Steph Wissink with Jefferies. Please proceed with your question.

Steph Wissink, Analyst, Jefferies

Thank you. Good day, everyone. I wanted to follow-up, Doug, on your comments regarding how the basket is shifting for consumers. I think you mentioned in the proteins category and even some areas of private label strengthening. Maybe take us into the household budgeting that you’re seeing with respect to your transaction structure. And then as you’re looking at your guidance for the back half, maybe a follow-up would be what you’re assuming in terms of the basket composition class of good or even within private label versus national brands? Thank you so much.

Doug McMillon, Chief Executive Officer

Yes. John, you jump in here, too. I think what you should take away from Q3 and Q4 guidance is that we’re expecting the environment to look a lot like Q2. As it relates to the choices people are making, one thing to call out is the variety — all kinds of income levels shopping in different ways. We’ve seen strength in some categories. For those under the most pressure and most price-sensitive, private brands are stronger, pack sizes are different. Opening price points — John might talk a bit about what you saw at the store manager meeting, for example how we protected opening price points for things like the Thanksgiving meal. The team’s doing a great job protecting opening price points for people that are most price conscious.

John Furner, President and CEO, Walmart U.S.

Steph, thinking back to planning we had in 2020, we’ve emphasized serving customers flexibly. Serving customers in store is something we have pressed on for a long time. Our pickup business continues, and delivery is growing. The variety of ways we can serve customers has been helpful, given changes in how customers live and work. When you click into products, our wide portfolio in e-commerce and stores, including our marketplace growth, gives us the ability to serve a wide range of customers. At last week’s manager meeting, what I heard consistently is the team is balancing improving quality and selling higher price points while remaining focused on opening price points. So having Thanksgiving meals positioned where you can buy an entire meal for under $50 for a family of four is exciting. There is a value play and a quality play and we will be ready to serve wherever the customer goes.

John David Rainey, Executive Vice President and Chief Financial Officer

Steph, as it relates to our guidance in the back half of the year, the swings that we’ve seen in consumer behavior have been difficult to predict and the pace has been sharp. Our guidance for the back half really assumes no significant change from what we saw in the second quarter in terms of mix changes in our business.

Operator, Operator

Thank you. Our next question is from the line of Michael Lasser with UBS. Please proceed with your question.

Michael Lasser, Analyst, UBS

Good morning. Thank you so much for taking my question. Welcome, John David. Walmart’s been experiencing some discrete and arguably temporary factors that are weighing on its profitability this year, including staffing issues in Q1 and the well-documented inventory issues. So looking towards next year, when some of these inflationary cost pressures are going to seemingly roll back and you’ll have moved through some of the challenges and the underlying drivers of the operating profit growth should continue, why wouldn’t Walmart be in a position to generate growth above its long-term algorithm in 2023?

Doug McMillon, Chief Executive Officer

Sure. You’re right that we’ve incurred some costs this year that are more one-time in nature related to supply chain and higher inflation, but it’s difficult to predict how long that will persist. The inventory situation has improved, but the effect on mix changes in our business, largely driven by higher inflation, may persist for some time. We’re being cautious with respect to the outlook. We’re not giving guidance for next year right now. But the conviction we have in our long-term plan has not changed. When you look at the long-term plan laid out previously — the flywheel strategy and the ability to grow operating income faster than revenue over a multiyear basis — we have as much conviction today as we did when we laid that out. We’re excited about the future, but the short-term period is uncertain and we’re being cautious.

Operator, Operator

Thank you. Our next question is from the line of Edward Yruma with Piper Sandler. Please proceed with your question.

Edward Yruma, Analyst, Piper Sandler

Hi, good morning. Thanks for taking the question. John David, curious on your perspective, given your experience on advertising and fintech businesses, how do you assess where they are today? And how do you think about the longer-term growth opportunity? Thank you.

John David Rainey, Executive Vice President and Chief Financial Officer

I appreciate the question. I’m a believer in what’s happening in digital payments and fintech and the secular tailwinds with consumer behavior moving more digital. The investments Walmart has been making are in those areas — expanding e-commerce capabilities, marketplaces and getting into financial services. From my early look at the company’s efforts, I’m very impressed with the breadth of capabilities and the resources devoted to these areas. I think it’s a huge opportunity for Walmart going forward and one of the reasons I was excited to join the company.

Judith McKenna, President and CEO, Walmart International

It’s worth adding some color on PhonePe in India. We visited recently and the update in the prepared remarks shows annualized TPV up to 830 billion and monthly transactions of 3.1 billion. They are approaching merchant services, and that two-sided network is important. They are also expanding into financial services with a focus on insurance. Their knowledge and ability to share best practices around the world, such as with Mexico, is a real benefit of being a global company.

Doug McMillon, Chief Executive Officer

On advertising, the relationship between digital growth, marketplace growth and advertising is something we’re positioning to take advantage of. In the U.S., the ability to attribute sales to in-store transactions makes us uniquely positioned. We’ve made enhancements to improve advertiser performance and the overall customer experience.

John Furner, President and CEO, Walmart U.S.

Knowing more about customers and the way they shop, including growth in pickup, delivery, Plus, marketplace and e-commerce, helps us identify the right sellers and suppliers. Walmart Connect can connect them, making the advertising business accretive to the P&L and also accretive to the customer experience by helping customers find the products they want.

Operator, Operator

Our next question is from the line of Kelly Bania with BMO Capital Markets. Please proceed with your question.

Kelly Bania, Analyst, BMO Capital Markets

Hi. Good morning. And I will add my welcome to you, John David. A lot of comments on the inventory, but can you clarify the dollar amount of inventory that you estimate would be excess? And can you help us understand how much of that is in apparel or other categories and the magnitude of markdown that you expect to clear through that and the timing of when you expect to get back to a clean position? And do you think that discounting from you and others in the industry could pull forward some demand from the second half? Have you considered that into your second half guidance?

John David Rainey, Executive Vice President and Chief Financial Officer

Sure. If you think about the U.S. inventory increase in the second quarter of about $11 billion, about 40% of that is due to inflation. So, when you normalize for inflation and growth effects, you really whittle that down to about $1.5 billion of inventory that is above our optimal levels — the amount we would most want to eliminate. We will sell through that inventory over time. In terms of types, the inventory issues were most acute in apparel in the second quarter. As we look into the third quarter, home and electronics and apparel are areas that stand out as the ones to work through.

Operator, Operator

The next question is coming from the line of Simeon Gutman with Morgan Stanley. Please proceed with your question.

Simeon Gutman, Analyst, Morgan Stanley

Good morning everyone. Still focusing on gross margin, the U.S. gross was down about 106 basis points in the second quarter. Can you comment how much is mix versus markdown? And to us, it looks like the mix is not getting any worse, if that’s fair. And then the clearance levels in Q3 versus Q2, will clearance/markdown occupy a greater proportion in the third quarter versus the second?

Doug McMillon, Chief Executive Officer

Simeon, if you look at the 132 basis point consolidated gross margin decline, three things contributed in order of magnitude: markdowns were the largest, then mix, and then the LIFO charge in Sam’s. There are other smaller items as well. As it relates to markdowns in Q3, we feel like we are in a better inventory position and those are related. We would hope not to see the level of markdowns experienced in Q2, but that assumes nothing changes with the consumer. We are being cautious in the outlook.

John Furner, President and CEO, Walmart U.S.

In the U.S., we did not have the LIFO charge, so a larger portion of our margin pressure was apparel markdowns. We have more work to do, but we are close compared to where we were pre-pandemic. Apparel was the issue we worried about most in Q2 because the goods are purchased far in advance and needed to be moved. In Q1 and Q2 the backlog of containers worked through and created a lot of inventory sitting in the network. We have largely gotten out of the container storage and movement business and have the inventory in the network. We have a good handle on what we own and where it is. As we said at the end of Q1, this would take a couple of quarters to work through, and that remains true. We will sell it and work through it; there will be some markdown liability, but apparel was the biggest skew that we addressed.

Dan Binder, Senior Vice President, Investor Relations

Simeon, on your mix question, if you go into our filings, you will see our mix change year-over-year, and you will see that in Q2 as well when we file our 10-Q. At the end of Q1, mix was a fairly significant shift as we were lapping stimulus spending. We recalibrated our expectations at the end of Q1, and then Q2 was even worse than expected, which is reflected in how we look at the back half. So we want to be cautious despite strengthening sales late in the quarter.

Doug McMillon, Chief Executive Officer

I would add one more thought: fuel coming down in recent weeks is helpful, but per gallon national averages are still significantly above last year. Food inflation also matters and in Q4 last year we began to see food inflation tick up, so the 2-year stack on food inflation will be something to watch. As we work with merchants, decisions are being made atom by atom, category by category, because we don’t want to go too defensive where new, exciting seasonal items can sell well. We canceled some orders and adjusted so we don’t end up too conservative in areas where we should be aggressive.

Operator, Operator

Our next question comes from the line of Robby Ohmes from Bank of America. Please proceed with your question.

Robby Ohmes, Analyst, Bank of America

Hey. Good morning. Thanks for taking my question. I think a follow-up on that, Doug. It’s probably harder for you to predict where fuel prices are going, but you have some visibility on food inflation given how large you are a player in that. It accelerated a lot in the second quarter. Has that continued in the third quarter? And does the guidance assume it stays at the level of the second quarter, or could it be up more in Q3 before maybe it fades against the comparisons in the fourth? Any color on what you are assuming would be great. And a quick second one for Kath: Sam’s Club home and apparel comps were much stronger. Was that all clearance, or is there something different between Sam’s and Walmart U.S. in terms of home apparel sales?

John Furner, President and CEO, Walmart U.S.

Hey Robby. Regarding food inflation, it definitely moved up in the second quarter and moved up across the months. July was higher than June and June higher than May. It’s too early in the third quarter to call whether it will continue higher or moderate. For now, we are assuming the level we saw in Q2, but that could change. Some costs that go into food pricing include the cost of moving food, and diesel fuel coming down could be a tailwind. Some categories show prices coming down while others are still rising. Too early to declare a trend.

Kath McLay, President and CEO, Sam's Club

On home and apparel at Sam’s, it’s a multiyear story, not clearance. It’s the investments we’ve made in quality in home, apparel and seasonal. We’re seeing better quality brands resonate with our member base and that has continued into this year.

Operator, Operator

Our next question is from the line of Rupesh Parikh with Oppenheimer. Please proceed with your question.

Rupesh Parikh, Analyst, Oppenheimer

Good morning. Thanks for taking my questions. On the markdown front, can you comment on what you view as excess markdowns as we try to think about next year? And secondly, on Sam’s Club gross margins declined nearly 300 basis points. Do you expect any of that to be structural, or do you expect recovery over time?

John Furner, President and CEO, Walmart U.S.

On markdowns, break it into pieces. Last year and the year before there were few markdowns because we were chasing demand and ended seasons very cleanly. Returning to normal seasonal markdowns is normal. We are trying to manage sell-through season-by-season compared to historical rates pre-2019. The business is larger now, which changes purchase volumes and the amount bought versus demand. For Q4, we have canceled billions in orders and feel better about the back half of the year. We still have inventory to work through and ingest from backlogs, so it will take a couple of quarters. Heading into next year, purchasing levels will be more in line with current demand and mix, though macro factors could change that.

Kath McLay, President and CEO, Sam's Club

For Sam’s, our gross profit rate was affected by two major things: a LIFO charge of $123 million and markdowns. Much of the markdown amount was a strategic decision to create an inventory reserve for Q3. That effectively pulled some markdowns forward into Q2 to set us up for a strong Q3 and to be competitive going into the quarter. I don’t see that as a structural trend; it was a quarter-specific choice.

Operator, Operator

Our next question is from the line of Joe Feldman with Telsey Advisory Group. Please proceed with your question.

Joe Feldman, Analyst, Telsey Advisory Group

Hey guys. Thanks for taking the question. Wanted to check in on what you are seeing with the supply chain these days. I know fuel cost has come down, and container prices have come down. But are you getting a more regular flow of inventory as you need at this point, or just your view of the global supply chain would be really helpful. Thanks.

John Furner, President and CEO, Walmart U.S.

Joe, let me start with a big thank you to our supply chain team and merchants — they’ve made a huge difference. The backlog of containers that started last fall when ports backed up has been worked through. Container costs are down from their peak but remain higher than a year ago. Fuel costs have come down from peaks but are still elevated and those costs flow through. In general, we see better flow and better availability. Our availability rates in food and consumables are much better than a year ago, but we still have work to do to return to 2019 levels. Inventories backing up earlier caused pressure on getting the right inventory to the right locations. We are optimistic improvements can continue as inventories come down, but it will take a few more months to work through the backlog.

Doug McMillon, Chief Executive Officer

From a P&L cadence perspective, supply chain costs became more pronounced in Q4 last year, so that will make comparisons easier for operating income in Q4 versus Q3.

Operator, Operator

Our next question is from the line of Chuck Grom with Gordon Haskett. Please proceed with your question.

Chuck Grom, Analyst, Gordon Haskett

Hi. Thanks very much and welcome John David. When you unpack the factors behind the better back-to-school and strong finish in July, and it sounds like in August so far, how would you rank the key contributors? Lower gas prices, there was a big uptick in state tax holidays this year versus last. And has the improvement altered your view of the upcoming holiday season in any way in terms of how you think the consumer is going to react?

John Furner, President and CEO, Walmart U.S.

Good morning. Three factors stand out. One is more customers shopping the brand than previously, including better traffic. Two, fuel prices came down through July. Three, school attendance levels are generally higher — fewer remote schooling situations compared to last year. Those contribute to increased spending late in July and early Q3. Regarding the rest of the year, there are still unknowns. If fuel continues to move down that would help. We’ll watch how the consumer shapes up. I’ll reiterate our commitment to the long-term view. It’s been great to see improvements in areas of the flywheel that are adjacent to retail that will help the overall business over the long term.

Doug McMillon, Chief Executive Officer

On better-than-expected Q2 performance, supply chain costs came in better than we expected and that helped. At quarter close, there are many puts and takes; in Q1 some items came in worse than we expected and in Q2 some came in our favor. That contributed to performance relative to our prior guidance.

John David Rainey, Executive Vice President and Chief Financial Officer

When you think about supply chain costs, we were getting unusual invoices in recent quarters such as container fines and excess fuel charges. We had expected higher cost, so the quarter felt favorable relative to that expectation.

Operator, Operator

Thank you. Our final question will be from the line of Ben Bienvenu with Stephens. Please proceed with your question.

Ben Bienvenu, Analyst, Stephens

Hey. Thanks. Good morning. When you move through a cycle like this with consumers trading down between price points and you gain market share and pick up new customers, how sticky does that share end up being on the other side of this inflation? Might we see this bolster your long-term share position and maybe leave you guys coming out of this environment in a stronger position with the consumer? And as a follow-up, you noted you are seeing middle income and some helpful trading into Walmart. What are you seeing from lower-income households? Are you seeing any trading down away from Walmart?

Doug McMillon, Chief Executive Officer

We certainly hope to hold share around the world. This inflationary environment will last for a while and will keep people value conscious, which plays to our strengths. We want to grow pickup and delivery worldwide and grow share of customer spend in stores. Generally we are holding at the lower end and adding at the upper end. We think these consumer relationships can be maintained, and our omni capabilities and services like Walmart+ help solidify those relationships.

John Furner, President and CEO, Walmart U.S.

We have seen pickup in past cycles, such as 2008–2009. But today the business is different: we have much more digital capability, pickup, delivery, Walmart in-home and Walmart+. Our ability to serve customers in many ways is much stronger than 13–14 years ago. That will be important to hold on to new customers. We are focused on satisfaction scores, delivery accuracy, and first-time pick rate to keep these customers engaged. We have more tools to be flexible and retain customers than we did in prior downturns.

Doug McMillon, Chief Executive Officer

We plan to sell more Walmart+ memberships to help solidify those relationships, and the Paramount+ addition should help.

John Furner, President and CEO, Walmart U.S.

We’re excited about the Paramount+ announcement. The brand has programming for kids, live sports, movies and drama — a wide variety our members will enjoy. This was member-led research; entertainment was the top benefit members asked for outside of delivery, and that led to adding this benefit.

Operator, Operator

Thank you. At this time, we have reached the end of our question-and-answer session. I will turn the call over to Doug McMillon for closing remarks.

Doug McMillon, Chief Executive Officer

Yes. As usual, thanks for your attention. We appreciate you focusing on our company. I will just wrap up with maybe three points. First, hopefully you are seeing in the results and hearing from us that we are making progress. We are addressing our inventory issues. We are pricing to reflect our cost structure. Second, more people are choosing Walmart and Sam’s Club and our brands around the world. Bodega business in Mexico, for example, is really strong. So, being able to attract more and more customers and a more diverse set of customers is a positive for us. Third, we are continuing to change the business, execute our strategy, grow e-commerce, drive digital transformation, grow the marketplace, and expand related businesses unlocked by this transformation. Regardless of short-term pressures, we are making progress toward the longer term. We certainly hope to put the pressures we have faced in the first half behind us as quickly as we can and claw back the operating income percentage delta that we experienced in the first half as fast as possible. But as reflected in our guidance, we acknowledge reality: the world is feeling various pressures, most pronounced from inflation. We think we are in a good spot to continue to make progress, and when customers and members are focused on value, that plays to our strengths. Thank you, all.

Operator, Operator

This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.