How Sam's Club sees the future

Sustainability: 'I remember the first conversation that Lee had with a group of us,' recalls McMillon. 'I really didn't understand what he was talking about.'

Yesterday: The original Sam's Club.

Today: The modern version of Sam's Club.

Got milk: The stackable jug is part of Wal-Mart's green policy.

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(Fortune Magazine) -- Running a major retailer amid economic tumult can't be easy, but Sam's Club CEO Doug McMillon, 41, faces unique challenges. Sam's is so big - 2007 revenues were $44 billion - that if it were a freestanding company it would rank No. 52 on the Fortune 500, and finding growth at that size can be tough. But Sam's is just part of a far huger company, Wal-Mart, which is counting on Sam's to help fuel its own growth.

McMillon, who started working at a Wal-Mart warehouse as a summer job in high school, has grown Sam's impressively during his three years as chief; he has consistently increased same-store sales faster than those at Wal-Mart stores. But Sam's profits fell in the quarter that ended July 31, reflecting the pressures on retailers generally.

McMillon, widely considered a possible future Wal-Mart (WMT, Fortune 500) chief, talked recently with Fortune's Geoff Colvin about how the slow economy is changing consumer behavior, how he feels about Sam's Club Republicans, what will be selling this Christmas, and much else. Edited excerpts:

One of the most important questions regarding the economy is how all the tumult on Wall Street will affect the American consumer. Nobody has a better perspective on that than you. So what do you think?

Fuel prices are really a pressure point, and they have had an impact on food and other things as well. So what happens on Main Street right now, more so than on Wall Street, is that people are having to watch pennies more than they might have a year ago and are making tradeoffs. They're making decisions about what they must have and then making a few discretionary purchases - but we've seen fewer discretionary purchases in the past few months.

On the whole, are they spending less? Gasoline is more expensive, but you sell gas as well. What is the net effect for you?

I think at the end of the year, when you add it all up, they will have spent slightly more, but the growth will be less than we've seen in recent years, and they'll spend it on dramatically different things.

Like what?

Take gas off the top, and what it costs to heat the home as another big drag on the wallet, and then food inflation of 4% to 5%, which is a big number for the average U.S. consumer. So you'll see a bigger portion of the check going toward energy and food and less on things like electronics, though they'll still have the coolest cellphone as they prioritize those discretionary purchases. We're still selling a lot of flat-panel televisions.

But the home category, which would include sheets, towels, furniture - things like that - has been under pressure. Although our team has changed our sheet program and our towel program, our sales are actually really good, which just goes to prove that if you have the right item, they'll find a way to pay for it. You may take share from somebody else, but they'll find a way to pay for it.

Do you have an economic forecast?

We don't think next year is going to look a lot better than this year. I wish you could tell me what gasoline is going to be. As we think about next year, our focus is going to be very similar to this year - manage your expenses, be thoughtful about how you spend capital, and within those discretionary categories, take some risk but have conviction about where you take risk.

We've got a Halloween assortment out there right now that I'm excited about - fun things that stand up, make noise, scare kids, inflatables that look like haunted houses and things like that. I think we're going to sell that merchandise. It may sell late, and we may not sell as much as we would like, but people still want enjoyment in their life, and one of the reasons they come to us is for that enjoyment.

Your boss, Lee Scott, has made sustainability a big theme for Wal-Mart. Is it actually helping your business?

Yes. It's been an interesting journey. I remember the first conversation that Lee had with a group of us, and I didn't really understand what he was talking about. "Sustainability" was defined in a financial sense for me. As he started to broaden the conversation into the environment and then social issues, it sounded like potentially a big distraction. But in fact it fits within our overall mission - to save people money so that they can live better.

We underestimated how much financial benefit we could get from it. We found items that if you simply reduce the amount of packaging involved, save cost, and pass that on to the customer, you sell more. You're just eliminating waste. We thought we were efficient before, but we really weren't. It was as if somebody handed us a different pair of glasses, and the whole world looked different.

Any benefits beyond cost?

Yes, we got a secondary benefit that I also don't think we understood. Many of our associates have an emotional connection to this subject. When we started declaring goals, some of them very aggressive, the path to achieving them not clear, they responded in a way that was surprising. They said, Count me in, let me have a piece of that responsibility, and I'll help figure it out. Now it's moving with two million associates behind it, not just a small group of leaders.

Sam's Club recently adopted a new milk jug that got a lot of attention. It looks like a rectangular block. What was wrong with the old milk jugs?

Of all the things you might think you could innovate on, the milk jug might not be at the top of your list. But traditional milk jugs don't stack, and they were coming in on metal carts that were being shipped back to the dairy, cleaned, and then sent back to the stores and clubs, and recycled, which created a lot of energy drain.

The new milk jug is stackable, so in a trailer you can get 400 additional jugs. You don't have the carts going back to the dairy. It's also loaded in a way that reduces bacteria, which gives you additional shelf life. So we have 20 days of shelf life here compared with 14 days before. It's a better-quality product, and it actually costs a dime to 20 cents less, depending on the dairy. We've eliminated 11,000 delivery trips to Sam's Club by moving to this jug. The one big challenge has been that it's different to pour. If you tip it and put it into the glass, it works fine, but if you pick it up and pour it like the old jug, you'll miss. So we've had a lot of people crying over spilled milk.

Despite the well-known futility of that! But otherwise are there no tradeoffs?

That's the only tradeoff.

At least 15 major retailers have filed for bankruptcy this year, vs. only seven in all of last year. Why is the industry being shaken out so violently in your opinion?

I think it relates directly to discretionary purchases. Look at retailers that have been having a difficult time - the consumer shifted money toward basics, and if you're dependent on specialty apparel or some specialty hard line, I'm sure your trip count was impacted. At Wal-Mart and Sam's we have basic necessities, and that value position creates traffic. So in an environment like this, we have a bit of a hedge, and many retailers don't.

How are your growth prospects abroad?

Outside the U.S. is a big opportunity. We're well established in Mexico and Brazil, and have over 100 units outside the U.S. Some of our most productive units are in Asia. We're really excited about our units in China and have a big opportunity to grow there. I don't know how many you could build, but I think over time it's more than we have in the U.S.

Wal-Mart did not succeed in Germany. What were the lessons from that experience?

We tried to take two companies that weren't doing particularly well, merge them together, give them entirely new systems, and embed a culture from Arkansas, all in about 15 minutes. I think that sums it up.

In the business of membership retailing you're up against a very strong competitor, Costco (COST, Fortune 500), which is bigger than Sam's Club. How do you create a competitive advantage against it?

We can't copy. If you want to copy somebody, you're going to be second at best, and always a step behind. So we're trying to be very deliberate about creating our own vision of the future and our own mission. We have this wonderful benefit of being part of Wal-Mart, so we can leverage logistics, information systems, our real estate team. In some cases we can build relationships with suppliers that benefit the supplier by working with both Wal-Mart and Sam's, and we try to gain some benefit by doing that. But we have room to improve. In warehouse clubs there are basically three of us now [the third is BJ's Wholesale Club (BJ, Fortune 500)], and the two that we're competing with are both very good.

Wal-Mart has a reputation as a very advanced user of information technology. A few years ago the company was pushing radio-frequency identification (RFID), which was going to revolutionize retailing, but so far it has not really done so. What happened?

There were a lot of hurdles to overcome, but we're still committed to it, and I believe in it. The global acronym has become EPC, or electronic product code. We're using it today in several Clubs, where, for example, an associate can use it to locate a product because there are readers on the forklifts that remember where they placed it. In a Sam's Club that does not have EPC, you and I would be walking around for 15 minutes looking for those tables that the member is waiting at the front to buy.

What's yet to be determined is how much benefit there is in the rest of the supply chain. Some of our suppliers are finding benefit, others are not. What we're trying to think through is how many dollars are available through efficiency, and what should we do with those dollars. In some cases we may need to pay more for the product to get it tagged, but if you have ever seen an electronic product code checkout experience, you will be motivated to get this done. It's awesome. You really don't have to break stride going through the checkout.

What's going to be big this Christmas?

You're going to see iPhones and iPods continue to be big. In the toy world, I'm not sure how much of this is public, but you know how Elmo gets hot every once in a while. This Elmo that's coming out this year stands up and talks to you in more of a human manner - it's almost like a standup comic. I think that item may be hot.

Bikes are going to be big. Electric bikes are something that we're having a hard time keeping in stock at Wal-Mart. It makes sense - if you don't have a lot of distance to cover, an electric bike may be a good alternative. I hope we sell a lot of LCD TVs too, because we're going to buy a lot of them.

But margins are thin on the TVs, right? Though I guess with you they're thin on everything.

They are, but they're even thinner on TVs.

You're 41, and I don't know of anyone else in America at your age who is running as big a business as you run. What do you think was the most important factor in your being able to achieve what you've achieved?

I think it was the company that I selected to join. Unless you're there, you don't really understand it, and when you're big, people may assume that you've got bad intentions. But I joined a company that gave me a great opportunity and taught me a lot. I went to graduate school and paid good money to get an education that's worth something, but I learned more in the first six months at Wal-Mart than I learned in 5 1/2 years of post-secondary education.

A widely used phrase in this election season is Sam's Club Republicans. Has the use of that phrase had any effect on your business?

I don't think so. We don't track our members by Republican vs. Democrat - that's not one of the fields they check when they sign a membership card. I think Governor Tim Pawlenty of Minnesota is the one who used that phrase first, and I think he's a terrific guy.

I believe his point was to distinguish Sam's Club Republicans from country-club Republicans.

Yes, but if people who are members of country clubs want to shop at Sam's Club, that's okay with us too.