I saw your post a few weeks ago, and was at the time in the throws of upgrading my own daughters ride again. Now that we have had a few weeks with the new (used actually...) bike, I feel more 'qualified' to respond. Hope you don't mind a long winded answer!
My daughter is now nine, and on her 4th bicycle. I strongly believe that size does matter - kids should be on a bike that fits them correctly, and the extra spent on moving them up as their ability improves is rewarded by their general enjoyment, and fewer injuries. The first two were purchased new from "Toys R Us", with wheel sizes of 16" (with training wheels) for age 4, and 18" for age 6. They were 'cheap' bikes, but after an hour or two spent carefully playing with the preload on bearings, adjusting spoke tension, etc., they rode and stood up to use extremely well.
We also live in a hilly area, and I was anxious to move her onto a gear bike by age 7. I purchase a Pacific brand 5 spd 20" bike at a yard sale for $10, and again pretty much dismantled and reassembled it until it was just right. I believe it was also originally sold at "T R U". But I would not let her ride it for a few months. I first fitted a rear handbrake to the 18" bike, and worked with her to learn to break her reliance on the coaster brake. Then when she was 'rightsized', we moved up. Within a few weeks we were doing not only paved surfaces, but some 'fire trail' paths that lead into some more extensive dirt. I changed the front post and handlebars last year to ones that fit her better as she grew.
This summer it was evident (now age 9) that she needed larger and better. 5 spds were a frustration on more demanding hills, plus we had max'ed out all adjustments. Off to the LBS for something better. The salesman tried to advance her right to a small framed 26" wheel, but it was evident to me that she was unstable and uncomfortable with this big a jump. She got on a demo/used Giant MTX 225 (24" wheel) and fell instantly in love. She zipped around, dialing thru 21 gears like she had been doing it for years. Yesterday we did a hilly development, then a few mile ride thru deep woods following some motorcyclist tracks. A good time was had by all. I'm the one who now needs a bike upgrade, as my Trek Navigator 200's stance and tires were not cutting it! Yes, I will probably be back for the 26" bike for her in a year or two, but that is fine. I have a second daughter coming up on her 3rd birthday, so my cellar 'inventory' will be put to good use!
So what is my feeling on Walmart vs. LBS? If you are mechanically inclined, there can be decent value in dept store units. What separates them from the entry level LBS ride is, in my humble opinion, number one - service/assembly/adjustments, and number two - frame quality. A lot of the basic running gear (SRAM 3.0, Shimano Tourney, or the like) can be found on either. You have to go upmarket a bit to really break into better subcomponents. When the bike is taking hard knocks and occasional mishaps dealt out by younger kids, I felt better about it being the dept store stuff. Now that she is more responsible, the LBS makes more sense to me. The other day she razzed mommy about taking over her K2 Rosario bike in a year or so. I guess maybe both parents will need to get new bikes!
Steve