(FORTUNE Magazine) – No. 1

By some financial measures, the No. 1 company in the FORTUNE 500 had a pretty good year in '04. Wal-Mart yet again defied the laws of large numbers, with sales climbing 10% to an astonishing $288 billion. Profits rose 13%, to more than $10 billion, in spite of a soft Christmas season. (For more on how it drives its business, see following story.)

And yet Wal-Mart is embattled as it has never been before. Sex-discrimination litigation, wage and pay disputes, fights with unions, and other workplace problems have left the company at loggerheads with plaintiffs lawyers, federal investigators, and even the chattering classes. From Chicago to New Orleans to California to New York (never mind Quebec and Mexico), news that Wal-Mart is coming to town is now often greeted with protests. Every week, it seems, a new untoward story comes to light: a multimillion- dollar settlement with immigration authorities over illegal workers; the resignation of a top company officer after allegations of financial improprieties; lawsuits delaying construction of dozens of Supercenters in California, a market critical to the company's growth. With characteristic zeal and efficiency, Wal-Mart has marched itself straight into a management and public relations quagmire.

As with most things at Wal-Mart, the problem goes back at least in part to Sam Walton, the visionary founder and leader of the company until he died in 1992. Sam disdained the press, publicists, and government relations, regarding them as wasteful distractions. Focus on serving the customers, Sam said, and everything else will take care of itself. Even after the company grew large enough to draw criticism as a destroyer of small-town America, Wal-Mart's buyers and merchandisers were moneymakers and heroes, and its lawyers and personnel execs were cost centers and zeros.

But now Wal-Mart is the biggest company in the world--inevitably a global symbol of business power--and it can't get away with such corporate isolationism anymore. It has other constituencies that need to be taken care of--millions of employees and local citizens, for example.Yet Sam's successors too often have followed the letter of his rules, not the spirit. He might have been an obsessive merchandiser, but Sam never would have put stonewalling the outside world above growing the company. "I think if Sam were alive today he wouldn't be jumping for joy over all the external communications we have to do," says Jay Allen, Wal-Mart's senior vice president of corporate affairs. "But he would see the need for it now."

Until recently the company was unable even to admit that its world had changed, that it must address these problems. It is starting to do so now, but it has dug itself such a hole that so far it has not had much success. Wal-Mart has hired legions of publicists, lobbyists, and lawyers, and its senior executives have taken to giving tub-thumping speeches in defense of its actions. But the company's stock price is stuck where it was six years ago.

Defining Wal-Mart's problems isn't easy. Some have occurred because the company, now with 1.6 million employees worldwide, is just so big. Like other giant institutions (the military and post office come to mind), it is bound to have bad apples. Some problems stem from an ingrained attitude that the bottom line supersedes all. Some are the result of actions by antagonists such as unions. Still others seem to be the product of simple tone-deafness.

It is difficult, too, to assess the impact these problems have had on Wal-Mart's business. True, the company built or expanded 242 Supercenters in the U.S. last year--each producing an estimated $79.5 million in revenues on average, according to Morgan Stanley--and plans to build 240 to 250 more this year. But it has also had to scrap or delay plans to build stores in California, Illinois, and New York. Each unbuilt store is a marginal hit to revenues. And whenever there is a unionizing action or local friction over a new store, the company sends out lawyers, PR people, and anti-union teams--a marginal increase in costs. The flat stock price is attributable in part to what Deutsche Bank analyst Bill Dreher calls "headline risk." The overhang of a potential multibillion-dollar settlement from a gender-discrimination class-action lawsuit couldn't be helping matters much either.

To combat its problems, Wal-Mart has employed a variety of tactics, including carrots, sticks, money, lawyers, and jawboning. That's appropriate, given that it faces all manner of difficulties, but its actions can appear muddled and uncoordinated too.

Facing a raft of cases alleging workplace malfeasance, for instance, Wal-Mart is litigating some and settling others. On its website the company acknowledges that it is the subject of "more than 40 pending wage-and-hour cases seeking class certification status." Those are generally complaints in which employees claim managers tolerated or required off-the-clock work; the company is fighting the claims. On the other hand, the company recently paid a record $11 million settlement to U.S. Immigration and Customs Enforcement, settling a four-year-old federal investigation into the hiring of hundreds of illegal immigrants to clean floors at 60 stores around the country. The biggie, though, is the class-action gender-discrimination lawsuit certified last year, which could encompass the claims of 1.6 million women who have worked at Wal-Mart since 1998. The lawsuit alleges that women are underpaid and underpromoted relative to their male peers. It is the largest civil rights class ever certified and could potentially cost the company billions. For the time being, Bentonville is fighting this one tooth and nail.

As for employee misconduct, Wal-Mart CEO Lee Scott says he's now taking a hard line. "The world has changed, and so you have to react more dramatically and more aggressively, in a less forgiving, harsher way," he said in a recent interview. That seems to apply to the highest levels of the company. On March 25 board member Tom Coughlin, the onetime head of Wal-Mart's stores division, stepped down as a director. According to an SEC filing, Coughlin resigned because of a disagreement with the company over an investigation into alleged unauthorized use of corporate gift cards and reimbursements valued between $100,000 and $500,000.

When it comes to unions, Wal-Mart's stance is implacable. And this fight may provide the clearest example yet of how the company's adherence to the old ways of doing business is hurting it in the present.

In the mid-1990s, Wal-Mart's growth slowed, and CEO David Glass and chairman Rob Walton saw the need to move beyond selling dry goods to middle America. They decided to bet on the Supercenter concept of huge stores as large as 200,000 square feet that include a full supermarket. They would plop down these Supercenters everywhere, in Texas, Florida, and New York. And they began eyeing California, too, where the company had a small presence. The plan was a smash hit. Within a matter of years, Wal-Mart became a giant in the supermarket business, and the company's stock took off again. Supermarkets like Kroger, Albertsons, Safeway, and Winn-Dixie (now in bankruptcy) came under tremendous pressure, and so did the union representing many of the workers in those stores, United Food and Commercial Workers.

In 2002, Wal-Mart announced it would build up to 40 Supercenters in California. To compete, California grocery-store managements began looking to pare costs. The following year Safeway presented to its workers a contract that slashed medical benefits and wages. Safeway workers went out on strike. Soon thereafter the two other major chains in Southern California--Kroger, which owns Ralphs supermarkets, and Albertsons--locked out UFCW members at their stores. What followed was a bitter strike/lockout that left more than 60,000 grocery workers out of work until February 2004. In the end it was a draw--benefits were cut, but not as severely as management had wanted.

Today Wal-Mart has only three Supercenters in California (another three are under construction), compared with, for instance, more than 200 in Texas and more than 100 in Florida. Why so few? In part it's because lawsuits funded by local businesses and UFCW chapters are holding back construction. The lawsuits take advantage of California's tough Environmental Quality Act, which requires studies not only of wildlife and air quality but also of potential economic decay caused by store closings.

Wal-Mart officials say the suits will slow but not stop them. "The horse-and-buggy industry wasn't permitted to crush the car," argues Scott. "The candle lobby wasn't allowed to stop electric lights. Ultimately that's what this debate is all about."

There is a softer side to Wal-Mart's battle plan, though. For the first time the company is publicizing the millions of dollars it contributes to local community organizations. It is running a national TV image-advertising campaign. It has started a website, walmartfacts.com, to rebut its critics. It has engaged another PR firm, Hill & Knowlton, and it has hired dozens of communications specialists and dropped them into regional offices, state capitals, and Washington, D.C.

And not a minute too soon. Lots of big companies develop image problems, and a few even become part of a broad cultural debate (think McDonald's and nutrition policy). But Wal-Mart at this point seems to have moved into a league of its own. After a long critique of the company was published in the New York Review of Books, of all places, Scott responded with an open letter to the publication's readers. The University of California at Santa Barbara hosted a conference last April titled "Wal-Mart: A Template for 21st-Century Capitalism?" As you might imagine, the discussion was in no way Wal-Mart friendly. The conference's organizer, Nelson Lichtenstein, proposed this central thesis: Throughout U.S. history there has usually been one dominant company that essentially sets a benchmark living wage for the American worker. "Today that company is Wal-Mart, but its pay is so low, it can't be considered a living wage," Lichtenstein says.

On this point, Wal-Mart management says, there is a tradeoff. The more than a million Americans working at Wal-Mart are paid wages that might be higher, but if they were, Wal-Mart's goods would cost more, to the detriment of the 296 million of us who can shop at Wal-Mart. There is something coldly reductionist, though, about Wal-Mart's paying its workers so little that the only store where they can afford to shop is Wal-Mart. It brings to mind an old Bob & Ray routine, a fictitious interview with one Hudley Pierce, CEO of the Great Lakes Paper Clip Co. When asked how his employees can possibly live on a wage of 14 cents a week, Pierce responds, "We don't pry into the personal lives of our employees. But as I understand it, our people live in caves on the edge of town, and they forage for food." Wal-Mart argues that retailing has always been a low-wage sector, and that the company has actually raised the standard in this business.

Away from university campuses and journals of opinion, though, can Wal-Mart find a way to stem the tide of criticism? "I look at it this way," says Jay Allen. "Thirty percent of the country don't care one way or the other about Wal-Mart. Thirty percent love us. Thirty per cent have sincere questions about us. And 10% hate us. We need to focus on the 30% that have sincere questions about us and work to answer their questions."

Wal-Mart is learning, but in some cases it's still bungling. Last year it raised public ire in Inglewood, Calif., when it attempted to circumvent local laws and essentially construct a Supercenter in the dead of night. Locals got wind of the project, organized, and voted it down. Plans for a store there have been scrapped. "What we did in Inglewood was wrong," says Allen. "We have to learn from those mistakes."

But is it doing so? In Dunkirk, Md., a local ordinance was passed recently limiting the size of a store to 75,000 square feet to keep out big-box retailers. Wal-Mart has proposed building a 74,998-square-foot store there--and then erecting a 22,689-square-foot garden center right next door. That's following the letter of the law, but isn't it violating the spirit?

"We are going to find a way to serve customers," Allen says.

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