We’ve been poking at Walmart of late because the Bentonville giant appears to have feet of clay. It has been pursuing its relentless cost-cutting strategy to the point where it is damaging its franchise. Bloomberg (and later, the New York Times) described how the retailer had cut headcount to the point where it was having difficulty keeping shelves stocked and checkout lines to a tolerable length. Proving the validity of the Bloomberg account, over 1000 Walmart customers e-mailed the news service, describing their crummy experiences.

Walmart, in a classic demonstration of the behavior of an out-of-touch management, sternly denied the customer complaints, asserting that its impressively-large sounding customer surveys were more accurate and proved all was fine. Astute readers described how surveys like that could be and likely were gamed by store managers.

Walmart is an easy target for criticism. It’s a classic corporate welfare queen pretending to be the face of capitalism. It is the top driver in the increasing use of food stamps. Per a workforce study quoted in Daily Kos:

Wal-Mart’s poverty wages force employees to rely on $2.66 billion in government help every year, or about $420,000 per store. In state after state, Wal-Mart employees are the top recipients of Medicaid. As many as 80 percent of workers in Wal-Mart stores use food stamps.

It plays communities off against one another to get subsidies for new stores, when the primary beneficiaries are the local builders. Walmart is a wage reducer and business destroyer, so it’s hard to see how (once construction is completed) that it is a net plus to a community, unless it sucks revenues away from businesses in neighboring towns.

But Walmart is looking increasingly like a corporate one-trick pony. Anyone who has spent much time in big companies will recognize the symptoms: the environment changes, or the current strategy has simply run its course, leaving the company bereft of growth opportunities, and all management seems capable of is doing what it did in the past, only harder. Hence Walmart’s cost cutting to excess.

But Walmart may have started going off the rails even earlier than the counterproductive staffing cuts suggest. A story in Nation, on a whistleblower lawsuit, buries the lead. The title is “Former Walmart District Manager Accuses Company of Widespread Inventory Manipulation.” But if you understand the allegations, what he is effectively charging them with is accounting fraud, since that was the motivation to tinker with the inventories, to report better financial results.

And rest assured, inventory manipulation can rise to the level of accounting fraud. One classic technique is “channel stuffing” which is making shipments to customers and counting them as sales even if the shipments are in advance of orders. For instance, the SEC sued Bristol Myers for improperly reporting $1.5 billion in revenues resulting from selling excess pharmaceutical inventories to its two biggest wholesalers at the end of two quarters. Bristol Myers paid $150 million to settle the charges.

Now the problem with this sort of activity is that you get a one-shot gain, and you have to continue to engage in similar types of behavior to keep from having to reverse it. Say, as Bristol Myers did, you move $100 million in sales from the next quarter to this one by shipping extra product. So if your revenues, before your clever trick, would have been $800 million this quarter and $815 the next, you’ve just made them $900 million this quarter and $715 the next, unless you steal revenues from the quarter after next. And if you have growth targets, you might not just need to keep rolling $100 million forward now that you’ve gotten yourself on this treadmill, you’ll likely find it necessary to increase it to keep your pretty phony growth pattern going.

Let’s look at the Walmart charges. Sylvester Johnson worked in Walmart’s headquarters, got significant awards for his performance, and became a manager of 11 supercenters in North Carolina in 2003. He was fired in 2009 for manipulating inventory counts. Johnson says the claims are false, that he was outed for resisting pressure to misreport inventories, and was ousted for his resistance. From the Nation (hat tip Economystic):

“We’re talking about hiding tens or hundreds of millions of dollars in losses here—inflating the profits of a store, a district, a region, a division and ultimately the entire company,” Johnson told The Nation. In theory, such a practice could have artificially inflated the company’s profit margins and stock price, amounting to a form of federal securities fraud. Johnson claims that during his tenure as a Walmart district manager he was pressured by the company’s high command to hide losses due to “shrinkage”—defined as lost or stolen inventory—in order for stores to appear more profitable than they really were. Throughout the course of over six hours of interviews with The Nation, Johnson maintained that top management set shrinkage targets for Walmart Supercenter stores under his supervision that were “not ethically attainable” and then used methods of “fear and intimidation” against him in an attempt to compel him to meet those targets. Shrinkage represents a loss to any firm’s bottom line. It is a major factor in retail profitability… In June of 2008, a company executive named David Carmon took over as Walmart’s Regional Vice President for North and South Carolina. Johnson claims that, at the time, some stores in his district were losing about a million dollars in shrinkage annually. Carmon instructed him to cut his stores’ shrinkage rates in half—a target that Johnson felt was impossible to hit without resorting to unethical and illegal accounting practices. According to Johnson, Carmon warned of repercussions if Johnson’s shrinkage rate did not fall. “He threatened everybody that if you didn’t get your shrink down, you were going to be terminated,” said Johnson in a court deposition. Speaking to The Nation, Johnson said that Carmon used “tactics of fear and intimidation, and everyone looked the other way.” Johnson says that recorded shrinkage rates reduced to incredible levels in regions that Carmon oversaw. Carmon left the company in 2010, according to his LinkedIn page, which touts his achievements in reducing Walmart’s shrinkage rates in the Carolinas: “I successfully led some of the company’s largest operating units through remarkable growth and expansion, delivering strong and sustainable financial results. Most notably, the North and South Carolina region responsible for $15.5B in sales has seen a $60M+ reduction in shrinkage loss…”

Although the Nation story does not unpack all the details, Walmart curiously started investigating Johnson, who was one of the few black managers in the company, for manipulating inventory accounting in 2008. One imagines that Carmon anticipated that Johnson would go to higher ups and decided to get out in front of it. Johnson alleges the inventory gamesmanship was widespread:

Johnson says he reviewed the shrinkage rates of over 400 Walmart stores around the country and was astonished at what he saw: impossibly low inventory loss rates to the point that stores would commonly display a negative rate of shrinkage, known as on “overage.” An overage occurs when records show quantities of inventory on hand greater than what was shipped to the store—a sign of either accounting or shipping errors, or deliberate fraud. “It was a standard practice to look at [the shrink rates of] other stores because everyone competes with each other,” Johnson said. “When you see these overages in there that clearly should be investigated but the regional VP is saying ‘this is exactly what we’re looking for,’ or ‘outstanding job,’ it is a point of concern,” Johnson said. “I think there is an unspoken culture at Walmart that a store is allowed to have excessive overages if it makes that store and the company look more profitable.” “This could conceivably be done in some systems,” says Stephen A. Smith, a professor at Santa Clara University and co-editor of the book, Retail Supply Chain Management. “Walmart is famous for having really good information technology systems so that makes it hard to imagine, but maybe someone found a way to do it.”

Johnson has obtained information about the inventories in North Carolina and South Carolina, and is seeking to obtain information from other regions to show it was a company-wide practice. Needless to say, Walmart is fighting his requests.

If Johnson is right, this means Walmart was engaging in desperate measures to maintain its profit targets in 2008. And this would relate to their current self-inflicted wounds directly. First it points to a culture willing to take considerable risks to maintain the illusion of profitability. Second, it has direct implications for inventory management (emphasis ours):

“You could make your profitability look better by doing things like not reporting shrinkage, that’s true,” says Paul Huppertz, Partner at the Progress Group, a distribution and logistics consultancy. “But I struggle to understand how long you do that before you run into major bookkeeping issues.”

Huppertz says that consistent errors in inventory recording would make it difficult for any large company to keep its supply chain working efficiently. He has never heard of a company obscuring shrinkage loss to appear more profitable.

Now Johnson is arguing that he was terminated for race, not for being a whistleblower, since he never got that far. That might not be as bad a case as you think. This theory presumably would allow Johnson to demand the information necessary to have his records regarding how he accounted for inventories and managed the inventory shrinkage reduction program compared to other managers at his level. He might indeed be able to show that he was treated differently than white managers who had records similar to his. But the real issue is that Johnson does not need to get that far. This is the sort of case where he can do tremendous damage to Walmart in discovery. If the judge agrees to force Walmart to divulge inventory records from other regions, and they are as damaging as Johnson alleges, I’d expect Walmart to gear up settlement talks the second the judge’s order comes down. The last thing Walmart would want is to have that sort of information become public because it can open up very costly cans of worms.

I hope Johnson prevails in his discovery requests, and if he does, that he and his attorney understand the leverage they have over Walmart and use it to extract a rich award. Unfortunately, that means, either way, we are unlikely to learn the truth of Johnson’s allegations, unless, say, Mary Jo White decides to use this case to prove her bona fides. Either Johnson loses his request to get information about the other regions and has difficulty arguing his case or he prevails, and Walmart does what it needs to to shut the case down. But if Johnson is right, it means the rot at Walmart is more advanced than even its worse critics might realize.