My Take on Wal-Mart (WMT)
August 28th, 2007 by 
James Cullen
This page combines the two articles I just wrote on Wal-Mart (WMT).
As I mentioned earlier, for the next several weeks I plan on going through the 30 components of the Dow Jones Industrials in the hope of finding one or two good mega-cap buys. The first stock I picked happened to be near the bottom of the list alphabetically, and with shares also at the bottom of just about any range I could find I felt compelled to start with retailer Wal-Mart (WMT).
-Wal-Mart (ticker: WMT), with sales of $363 billion in the last year, is the world’s largest retailer. It operates traditional discount stores, “supercenters” that combine discount stores with grocery stores, and Sam’s Club membership warehouses.
-Wal-Mart’s dominant position in the retail business is a testament to the business model of leveraging economies of scale to achieve the lowest possible cost for goods, which it can then pass on to consumers. With the enormous scope and scale the company has achieved, it is difficult for competitors - even other big box retailers - to compete with Wal-Mart on efficiency metrics.
-WMT had a 22% increase in the short position in the last month as the stock fell to its 52-week low following the company missing quarterly earnings and softened forward guidance below expectations. Shares are now at an eight-year low, and at 14.5x earnings, are the cheapest they have been in more than a decade, trading at a discount not only to the industry average (16.6x) but also to the S&P 500 (20.4x). The 5-year average multiple for WMT is 25.1x earnings.
-Because Wal-Mart has high capital expenditures associated with new store openings, free cash flow is not the most accurate trailing metric to use with the stock. Management is now favoring a deceleration in new store openings (I view this as an admission of market saturation) and this will have a positive effect on FCF in the future, but for a company dependent on store expansions I favor operating cash flow as a valuation proxy. On this basis ($18.2 billion in trailing annual operating cash flow) the stock trades for just 11.84x cash flows on an EV/Op. CF basis.
-While Wal-Mart undoubtedly surprised the investment community with its failure to meet/beat expectations, one should put the quarterly results into the proper context. The company continues to generate an average return on equity in excess of 20%, as it has for the last decade, and overall margins continue to come in in the middle or high end of long-term averages. The cash conversion cycle continues to move in the right direction, and inventory carried as a percentage of sales is falling, meaning Wal-Mart is operating an even leaner business model. Similarly, inventory turn is at its highest rate ever, so that while same-store comps growth has been sluggish, it has not yet had any real adverse impact on financials.
-While many outsiders criticize the company for sacrificing profits for the sake of revenues, the fundamental model of Wal-Mart has always been ruthlessly leveraging efficiencies and making up the low margins on volume. Buyers of WMT can be assured that they have an extremely competent and frugal management team that, while perhaps not being renowned for popular products, can underprice/outsell just about any other company on the planet. Surely, this counts for something. Keep in mind that Wal-Mart just trails Exxon Mobil (XOM) for having the greatest sales revenue of any company, despite the fact that Wal-Mart does not make one thing it sells on its shelves. Consider, for a second, that the company sells $363 billion of other company’s goods, and keeps $12.5 billion of that for itself. Core competence? I think the management team at Wal-Mart is well aware of what their’s is and how they need to execute upon it.
-Given Wal-Mart’s anticipated earnings growth, its balance sheet position, cash flows, and business risk, the fair value target for WMT is $58.50, putting WMT shares as being undervalued by approximately 33.7% based off Friday’s closing price of $43.74.
The article I wrote yesterday on Wal-Mart (WMT) has been controversial, to say the least. Just about every point I made has come under siege from one direction or another - while I expected that my valuation target would get some decidedly negative feedback from shorts, I wasn’t ready for the backlash that came from people claiming to be former employees or general activists opposing Wal-Mart moving into their area. I don’t take moral stances with investments though, so I’m going to try to avoid wading into that sinkhole and focus on operational and equity-related issues. I have to wonder what percentage of people are part of the anti-Wal-Mart movement though, given that the company is the nation’s (and world’s) largest retailer with $363 billion in sales. An extremely well-publicized and vocal minority? Perhaps…
One common reason I see for selling or avoiding WMT is the argument that an economic downturn will have a negative impact on sales. While I see many valid reasons to be bearish on the economy, you can look for stocks that hold up better than average in a recession. The obvious example that I’ve covered of late is why you should buy American Eagle Outfitters (AEO) rather than another retailer like Abercrombie and Fitch (ANF), because looking at the same-store comparables changes in difficult retail environments clearly shows that Abercrombie desperately needs a healthy economy to grow, whereas American Eagle is more resilient. How does Wal-Mart stack up in this comparison? Consider that from 2001-2003, when real per capita GDP growth in the US average 0.49%, Wal-Mart grew revenues by an average of 10.3% per year; net income averaged a 13% increase - actually above the ten year average of 12.8%. What should you take from this? No, Wal-Mart isn’t likely to run off a string of double-digit growth years (I believe the consensus targets are completely overstated), but the company should do fine regardless of the challenges the retail market faces. Companies do not grow to $360+ billion in sales by sheer chance.
My most pressing concern about Wal-Mart’s business model is the sustainability of its core advantage; namely, the ability to be the lowest-cost provider thanks to massive internal leveraging of store infrastructure. This isn’t a truly unique trait that absolutely cannot be replicated, but it will be very difficult (though possible with enough financing) to approximate Wal-Mart’s scale. Still, a retailer like Target (TGT - which actually operates in an entirely different demographic) had sales of $62 billion in the last year, or about 1/6 of Wal-Mart’s amount, similarly, Costco (COST) had $64 billion in sales. The gap between Wal-Mart and the next-closest competitor is immense; yet WMT trades at a discount to industry and general market multiples, suggesting that there is more risk to the stock. Does this make sense?
I’ve seen suggestions that the reason the market is so down on Wal-Mart is tied to the low same-store comparables. This is certainly a valid point, as comps are checking in around 2%. Still, I have to wonder who buys WMT looking for high comps growth. It takes a lot to move the needle from where it is, and just about any marginal gains should be satisfactory - I have Wal-Mart priced in as being less than a 5% bottom line grower in my valuation model, and I still come up with the stock as being undervalued. This is likely a consequence of having $18 billion in operating cash flow and a 35% cash return on invested capital.
While there are many corporate PR issues surrounding Wal-Mart, financially speaking, the company looks completely sound. With the stock at multi-year lows and trading at historically large discounts to typical multiples, buying WMT with the right time frame and context (not a growth stock, remember?) should yield excellent market-beating returns.
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August 28th, 2007 at 7:12 pm
My problem with Wal-Mart is the exposure to China. It is cheap. It has been cheap and continues to be cheap. Twelve months from now it could be 55 to 60. Really would not shock me at all but I just don’t think the probability risk reward scenario is something I want to play with currently. I know the favorite line among bottom up value guys, including myself, is that we do not care about big macro picture things. Fine great. But you have Grantham who believes the Chinese Yuan is 50% undervalued. I have heard Buffett give a 25% range number. At some point that will change. It may take ten years and bleed the valuation gap away or you could get two or three massive revaluations. Either way that is bad for Wal-Mart. Wal-Mart gets what, 85% 90% of its retail products from China? (just throwing out numbers, no it is high but do not know how high) If it bleeds you are continually increasing your costs by buying those products in China. As a result you are constantly facing margin pressure. You either got to raise prices or find some additional efficiency somewhere to cut costs. Both I think are terribly difficult to do at this point for Wal-Mart. I have no idea what a large revaluation would do to Wal-Mart besides the fact that it wouldn’t be good. Wal-Mart was and is an unbelievable company. Yet I think it is a company whose business model thrives much more in a deflationary world rather than an inflationary one. For years we have lived in a deflationary world as production went to China and the outsourcing boom and margins expanded etc. We are not in that world anymore. You have inflationary pressures in China and the bottom has been reached in my opinion on most everyday goods. Will diapers (throw any every day product in) prices really decline from here? They declined in the past as production went overseas, the consumer did not capture the benefit (at least not much) but companies did earn higher margins. The result is a slow (hopefully rather than fast) inflationary world where I think Wal-Mart will have all kinds of head winds with margins. Like I said it would not shock me at all to see Wal-Mart at 55 or 60 in 12 months and there is probably some kind of floor close to the 40 level but I just do not like the story I see in my mind and I wonder if the market recognizes this somehow which is why it gives a discount to Wal-Mart’s valuation.
August 29th, 2007 at 12:19 am
The margin concern is a valid one and one that I had been thinking a lot about over the years. However, I am convinced that this factor alone should not deter me from buying Walmart - which is incredibly cheap on a normalized earnings basis. Certainly, there are 100 reasons for us to argue that the retail environment in 2008 will be tough, but I do not believe that people will stop buying goods altogether.
Going back to your point regarding yuan appreciation, I suspect that Walmart, along with many other major U.S. retailers, will eventually adapt. Why so? 1) The Chinese need to learn to fix themselves: not every mfr where Walmart source product from is large and efficient. For many of them, their survival depend on major U.S. retailers. Thus, they have less bargaining power when it comes down to price negotiation. Additionally, many of their transactions with U.S. retailers are still denominated in USD, so whose margin will get squeezed first? In the end, the manufacturing sector in China will either have to consolidate, be more efficient, or they will slowly give away business to the even-lower cost producers. This won’t happen overnight but it will happen eventually; 2) Elimination of middleman: Needless to say, middlemen have in the past captured a good chunk of the profit in the value chain. As direct sourcing become more and more common (and feasible), we should see many middlemen go out of business UNLESS they could prove that they add value. Li & Fung is a good example of a highly-regarded middleman. Anyone studying international trade needs to study Li & Fung.
Going forward, Walmart will certainly face competitive pressure in the US and aboard. Retailing is a tough industry to be in. That being said, there are many advantages for being the cost leader.
August 29th, 2007 at 4:49 am
WMT diluted EPS:
1987 - 0.1
1988 - 0.14
1989 - 0.18
1990 - 0.24
1991 - 0.28
1992 - 0.35
1993 - 0.43
1994 - 0.51
1995 - 0.58
1996 - 0.59
1997 - 0.67
1998 - 0.78
1999 - 0.99
2000 - 1.20
2001 - 1.40
2002 - 1.47
2003 - 1.79
2004 - 2.07
2005 - 2.41
2006 - 2.68
2007 - 2.71
They’ve passed through 3 stock market meltdowns, 80s lbo BUBBLE, internet bubble, LTCM, 9/11, asian crisis, you name it, and its earnings have grown steadily. returns of the stock during the last 5-6 years have been mediocre because mkt paid a stupid multiple, with PEs coming down from 30s to 14s now. If you want to bet on china revaluation or other reason, go long Yuan futures or whatever, but being afraid of Wal-mart because of that sounds like a terrible bet, specially with a 14 P/E.
August 29th, 2007 at 1:43 pm
On WMT’s Capex from 2007 10K:
“Capital expenditures for fiscal 2008 are expected to be approximately $17 billion, including additions of capital leases. These fiscal 2008 expenditures will include the construction of 5 to 10 new discount stores, 265 to 270 new supercenters (with relocations, conversions or expansions accounting for approximately 145 of those supercenters), 15 to 20 new Neighborhood Markets, 20 to 30 new Sam’s Clubs (with relocations or expansions accounting for 15 of those Sam’s Clubs) and 320 to 330 new units in our International segment (with relocations or expansions accounting for approximately 30 of those units). We plan to finance this expansion, and any acquisitions of other operations that we may make during fiscal 2008, primarily out of cash flows from operations. ”
The $17 billion in planned Capex alone will by no means contribute to a higher FCF number for WMT in 08 vs. 07, I think.
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August 30th, 2007 at 3:07 pm
From 2again’s post - How many retailers plan to spend $17B in Capex in 2008? this may be too controversial - however, the question is - isnt Walmart a growth story as well?
what do you think of Walmart’s international operations.. specially in China? it looks like they are trying to repeat their success in the US in many other parts of the world.
September 4th, 2007 at 12:20 pm
James, I could not agree with you more, well done, really good work. Despite Wal-Mart and all the evil they may stand for, I’d rather be profiting from them then listening to the greeters say ‘welcome to Wal-Mart’.
Amen brother
September 5th, 2007 at 2:28 am
Wal-mart appears undervalued with or without us putting much weight on the growth factor. But I like to think that we are essentially paying a fair price for a world-class discount retailer while getting cheap call options on its international business development opportunities, Sam’s Club, real estate, etc. Certainly, don’t expect an elephant to outrun a rabbit.
More specifically regarding the acquisition in China. I am often a skeptic of major international acquisitions but I think Wal-mart is taking the right steps by acquiring Trust-mart. Trust-mart has a decent brand in the Chinese market and more importantly, valuable retail footprint for Wal-mart to build scale. PR-wise, Wal-mart also seems to fare much better in China than in the States. Check out the WSJ article on Wal-mart’s Chinese acquisition if you are interested:
http://online.wsj.com/public/article/SB116155817934100326-1R9RPcuuo2NiakAxYK6g6WhHeOY_20071024.html?mod=tff_main_tff_top
Let me know if this answers your question.
September 16th, 2007 at 9:26 pm
James and Frank, I agree with you both whole-heartedly. Especially about the Wal-mart greeters.
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