Wal-Mart (WMT), with about 3,700 stores in the U.S., has steadily gained share of the domestic retail market over much of the past decade. Thanks to the opening of supercenters and relatively low prices, the discount giant’s  initial market-share gains during this period were  largely at the expense of supermarket chains and regional discounters. The supercenters average a whopping 186,000 square feet and feature a full line of groceries. The  keys to the discounter’s competitive advantage regarding pricing were overseas sourcing, mainly from China, very aggressive negotiating positions, relatively low in-store employee costs (including benefits), and economies of scale. In recent years, though, all major chains have adopted similar overseas purchasing operations. Also, unfavorable publicity, along with employee class action suits, have greatly reduced the disparity between Wal-Mart’s per-employee cost and that of other major chains.

Moreover, Internet-sourced sales by Amazon.com (AMZN), in particular, are a growing challenge to Wal-Mart and a number of other retailers. Wal-Mart’s Entertainment category accounted for 13% of fiscal 2008 sales, and it likely had the highest gross margin.  This business is the prime thrust of Amazon’s offerings, which, in addition to compelling prices, are increasingly favored by consumers due to an exceedingly wide selection and shopping convenience. Too, Amazon developed an electronic book display, dubbed Kindle, which was its best-selling item during the past holiday season. A much publicized “price war’’, related mainly to some best-selling books, was recently initiated by Wal-Mart, and it was immediately countered by Amazon, Target (TGT), and a few other retailers. The net effect on the sales and profits of these companies will be minimal, but the publicity amounts to free advertising.

Meanwhile, Wal-Mart greatly expanded its Internet marketing program in 2009. Taking a page from Amazon’s book, the Walmart Marketplace features goods provided by a number of small retailers. The company’ latest Internet category offers a comprehensive line of health and beauty items. Wal-Mart currently ranks second, well behind Amazon, in total U.S. Internet retail sales.  The next five Web sites, in declining order of sales, belong to Target, Sears Holdings (SHLD), Best Buy (BBY), J.C. Penney (JCP), and Toys ‘R’ Us (privately held).

Overall U.S. retail sales were little changed between November 1st and December 18th, despite easy comparisons, but Internet volume increased 4%, to $24.8 billion, according to comScore Inc. While e-commerce accounted for 6% of all U.S. retail sales excluding cars, travel, and prescription drugs in 2008, it likely represented about 7% of revenues in 2009. One important aspect of this upward trend is a negative impact on Wal-Mart’s margins and those of other primarily “brick and mortar” chains. Our thesis reflects the fact that Internet sales appear to reduce in-store traffic and purchases, which, in turn, increases a retailer’s expenses due to distribution costs. Moreover, relatively high promotional activity on the Internet tends to depress gross margins.

Another negative influence deriving from increasing Internet traffic is that fewer store visits moderates impulse purchases, which generally command relatively high margins.  Indeed, several retailers, such as J.C. Penney and Office Depot (ODP), have opted to open stores that are smaller than their traditional formats, and this trend will likely accelerate. Indeed, we expect mall-based openings to remain depressed for the foreseeable future. Finally, Best Buy and Staples (SPLS) are examples of chains that are expanding their service offerings to enhance sales and margins in the face of Wal-Mart’s growing presence in electronic and office supply goods. The former is focused on the concept of “connectivity” of many electronic gadgets within a home or office, while Staple’s current service thrust is in the area of copying and printing.

Wal-Mart’s U.S. Internet business will most likely generate solid annual sales growth for the foreseeable future, given management’s intent to continually expand the site’s  already very broad offerings, the company’s  well deserved reputation for relatively low prices, and its recent successful track record. Indeed, helped by the inclusion of other retailers’ wares, Walmart Marketplace has gained share in the Internet market over the past year and, as indicated above, it is now the second largest domestic Internet retailer. True, Amazon might continue to expand at a faster pace for a while, but the overall growth potential of Internet sales is huge. Also, Wal-Mart has a distinct advantage over almost all other chains, since its   Internet sites feature far fewer products. Finally, its operations in Europe, Latin America, and Asia will undoubtedly be increasing beneficiaries of Wal-Mart’s Internet capabilities.