Thursday, August 18, 2011

Walmart (WMT): Part Six - Is Walmart Cheap?

Last time we considered that Walmart market value has gone sideways for at least eight years. If we define owner earnings as the cash available for the benefit of equity owners either directly (e.g., payouts through dividends or share buybacks) or indirectly (e.g., reinvestment into profitable business growth), we can see that management has increased that from about $7 billion in 2003 to about $18 billion in the most recent full fiscal year. That's over 13% compounded annual growth. 

All the while, the stock price has gone from a peak of nearly $64 in 2003 down to about $50 today for a compounded annual SHRINK rate of 3%. So, it's clear that the share price and the value of the company have been at a disconnect. How does that relationship look today?
On the basis of owner earnings, at $50 per share the company is …

1. Very cheap on an historical basis. We saw this in the last post where Wal-Mart’s owner earnings multiple has dropped each year from 40x in 2003 to about 10x now, making it the cheapest it has been over the entire eight-year period.

2. Cheap to very cheap on a relative basis. Based on my rough estimates of owner earnings for some other key retailers, Wal-Mart is trading below all of them. Home Depot is currently valued around 15x owner earnings, Costco about 27x, Dollar General is 14x, and Target is 9x.

3. Pretty cheap on an absolute basis. 10x owner earnings implies that Wal-Mart produces a 10% yield for the benefit of owners based on the price they would pay to own its stock today. For my tastes, screaming cheap for a good company about 15% yield (~7x), but for great companies with strong prospects I can stomach as high as 20x owner earnings (5% yield).

All modes of cheap, however, are not created equal. It makes me think of the quip attributed to Woody Allen, "Just because I'm paranoid doesn't mean they're not after me." A business can appear cheap on a variety of measures and, more likely than not, it's cheap because it's legitimately not worth more than its price. There is a special danger inherent to making comparisons when trying to establish the value of a business, whether you're comparing it to itself (historical) or to similar companies (relative). Perhaps it appears cheap because it has exhausted all growth prospects that helped speculators rationalize its 40x valuation eight years ago. Or perhaps it ceded its competitive advantages to other retailers and now must fight in value-diminishing ways to maintain its market share. Reasons abound for cheap value matching cheap price.

That's not to suggest there is no benefit to reviewing historical or relative measures of cheap, but they must be steeped in two additional thought processes to make sure they aren't just leading you into a value trap.

The first is a relatively simple question you can ask yourself and treat it like a point on a safety check-list: Is the business cheap on an ABSOLUTE basis?

The full implications of that question are more complex than the check-list concept might suggest. It's largely a measure of placing the business in a state of suspended animation - taking a snapshot of where it stands today - and evaluating it as if it were an interest bearing investment. Take owner earnings, compare them to the price at which you're buying the business, and equate the percentage to interest paid against your principle investment. If the rate satisfies your return requirements, you can check the box.

For example, with Walmart trading at 10x owner earnings we can say that buying the business for $50 yields you $5 in earnings. If you return requirements are 10% or less, you have satisfied that checklist item.

Hypothetically, you could  stop here if you had good reason to believe Walmart will continue operating in AT LEAST as good a state as it currently exists.  You can say it's cheap on an absolute basis. But investing is rarely that simple. The second thought process can take you deep down the rabbit hole...

What does the future hold for this business?

The essence of investing is divining the future. Even if you're trying to check the simple box of whether a business is cheap on an absolute basis, you're making implicit assumptions that the business will continue generating the same amount of owner earnings into the future. That assumption requires further assumptions about access to and use of capital, competitive landscape, size of the market, etc. in what can seem a forever branching sequence of questions and even more assumptions. I'll avoid any attempt at the discussion here, but it's no stretch - when considering how variable A affects variable B changes variable C, ad infinitum - to say a business is akin to a chaotic system (using the physics definition) in which specific outcomes (the future) are by definition unpredictable and therefore unknowable. You will get it right from time-to-time, and perhaps even more often than not. But unless you have a reliable process for approaching it, you have no basis of saying your success (or lack thereof) is based on anything more than pure chance.

What is a reliable process for attempting to divine the future? One that confesses extreme ignorance of precise outcomes and gears itself instead to avoiding big mistakes. One that looks for advantages and still makes conservative estimates of future performance. One that eschews lazy-minded optimism in favor of a wide margin of safety.

Next, we'll discuss a way to think through margin of safety in valuing Walmart.

Thursday, August 11, 2011

Walmart (WMT): Part Five - Sideways Action Deflates the Value Balloon

In its fiscal year 2003, Walmart generated about $7 billion in earnings that went to the benefit of its equity owners. It paid a modest dividend, plowed the rest back into the business, and then borrowed another $3.8 billion to invest even more into its growth.

It was good times for the world’s biggest retailer. The company’s market cap hit $283 billion – more than 40x those $7 billion in owner earnings – revealing investors’ enthusiasm about the business; about their belief that it was going to grow and grow and grow.

And grow it did. Revenue has jumped from $247 billion to nearly $422 billion. It has reinvested over $90 billion to build new stores, strengthen its already formidable distribution and technology edge, and expand internationally. And those owner earnings have compounded at a rate of 13.5% each year since 2003, reaching $18 billion this most recent fiscal year, 2011.

Surely those investors who saw their digital certificates of stock blink up to $63.75 in 2003 have made out like bandits, riding the impressive operating results wrought by Wal-Mart’s management over the decade. Right?


As I write this, Wal-Mart’s market value is about $181 billion. That’s right. Despite years of business expansion, compounded owner earnings, dividends paid, and shares repurchased, the market value of the company is 35% less now than it was then.  Does this make sense?

Well, yes. It pretty much does.

Paying 40x owner earnings for any company is hard to justify. Wal-Mart, the great business that it was (and is), was overpriced.  What tends to happen in these cases is one of two things.

One, something about Wal-Mart’s operating performance, the stock market in general, the world economy, etc. spooks investors and sends them running for the exits, popping the inflated balloon that was Wal-Mart’s stock price.  This is common for hot “growth” stocks where the value depends on optimistic (nay, drug-induced?) assumptions of their continued growth. When circumstances no longer allow speculators to delude themselves, they panic and send the stock price into a nosedive with their selling. Don’t be surprised when you see this happen to… (CRM) selling at 191x its net earnings, Dunkin’ Donuts (DNKN) selling at 179x, or even a powerful force like (AMZN) selling at 83x.

Two, investors avoid an overreaction, but let the air out of the balloon one small deflating puff at a time. There is no panic, but no new buyers emerge for the stock at the high valuation and existing owners – perhaps realizing this, or perhaps recognizing that they bought too high, or perhaps from boredom that the stock price isn’t moving – start a slow sell. Though it lacks the excitement of a pop, the air just gradually seeps out. 

For owners of Wal-Mart at $63.75 in 2003, the process has been slow and excruciating. Things have just gone sideways for over eight years. The high multiple of owner earnings at which investors have been willing to buy the stock in any given year has drifted from 40x to 37…31…23…16x. And today, with a price hovering around $50 per share, Wal-Mart is trading at about 10x its fiscal year 2011 owner earnings of $18 billion (give or take).

So, the question becomes, is Wal-Mart now an attractive opportunity for new investors?

Thursday, August 4, 2011

Walmart (WMT): Part Four - EDLC-EDLP...Strength or Weakness?

In a conversation following the shareholders' meeting in June, Bill Simon (CEO of Walmart U.S.) took Q&A from Wall Street analysts. U.S. stores had endured something like seven consecutive quarters of comparable sales declines. With over 60 percent of revenue coming from Simon's division, these declines have become  the crux of the debate about whether Walmart can continue as a growing enterprise or if it's approaching saturation and decline.

With this in mind, Simon took the stage under the glare of the analyst klieg lights. Here is a slightly edited transcript between Simon and one participant:

Analyst: "Are your current operating margins sustainable? Is there opportunity for further improvement, or do you think you should give up margin to get the top line going further and faster?"

Simon: "In the long run I'd like to see our gross margins come down and our operating margins go up."

Analyst (incredulous at Simon's response): "Uh, how do you do that?"

Simon (unflinching): "Work really hard. Lower your costs. Sell more."

Analyst: "Um, I think that's what Walmart has done for 20 years and it looks like your operating margin is sort of steady where it is right now...So you don't think your operating margin is an impediment to sales growth?"

Simon: "I think the gross margin could be an impediment to sales growth."

Translation of Simon's stance: I want to charge even less for products than I do today, and I want to grow operating margin - irrespective of whether I finally increase revenue by getting existing stores selling more goods - by continuing to take expenses out of our operations.

In no uncertain terms, Simon is telling Wall Street that Walmart is going to keep dancing with the girl that got them to the party.


But Bill Simon has his job because Walmart did make a pass at more popular girl.

Expectations were high during the initial stages of the so-called Great Recession. This is the ideal environment for Walmart, so went conventional wisdom, because consumers will flock to its low-price offering. But the company seemed to stumble, initially attempting to grab and keep fat-wallet customers  stepping out on Target (that "more popular girl" if I can keep torturing this metaphor) by redesigning Supercenters, focusing more on chic products, and reducing overall selection to reduce the clutter feel. It was a departure, no matter how slight it felt at the time, from the EDLP theme.

And it didn't work. Rather than retain Target shoppers (it did not), Walmart managed to chase its core base of customers into the waiting arms of convenient dollar stores. The mistake generated two straight years of declining same store sales in the U.S., cost Eduardo Castro-Wright his job, made for a disenchanted investor constituency, and forced the c-suite to confess that it wandered from the tried-and-true.

Bill Simon's job has been to put Walmart US stores back on track, and he's doing it with a firm and public commitment to the old theme: "lower cost + lower price = more customers + higher volume."

The investment community should be overjoyed at this, right? Well, this is where the old yarn kicks in...that one about success having many fathers but failure is an orphan. EDLC-EDLP converted plenty of non-believers when it was the driving force behind making Walmart the fasting growing retailer in history (up to that point at least) with few signs suggesting that expansion would stop anytime soon. It was driving double-digit growth through existing stores and finding plenty of opportunities to open new ones at a blistering pace.

But that sort of growth is behind us now. No matter your views on Walmart's current ability to expand its store base, it's hard to argue that even the most optimistic scenario has that growth at low single digits. It's just the reality of a business getting large and testing the limits of its market size. So here's the challenge if there are fewer opportunities to grow Walmart's earnings through increasing its store count...where does growth come from?

There are three major sources:

First is international expansion, and it's a good one. In fact, it has been the driver of most of Walmart's overall growth since domestic sales slowed down. But international growth does not come easy, seems to carry a higher base of expenses (and therefore less profit), and runs up against a lot of entrenched retail competition.

Second is the internet. Walmart has to compete here, but it's going to have to find out its unique way of doing so. It will not work in a pure head-to-head battle royale versus The company is doing a lot of good work to figure out how the internet can complement its physical retail business, but when looking for growth on top of its existing $420 billion sales...well, it would have to match the business amazon has spent 17 years growing to $40 billion to move the needle. Amazon is in a dominant position and has the resources to compete ferociously to keep it that way. Walmart has to play in this arena if only to avoid ceding more territory to amazon.

Finally, there's domestic same store sales growth ("comps"). The US market continues providing the lion's share of Walmart's revenue and profits. If this market is truly saturated or (worse) the Walmart model is no longer attractive to American consumers, then Walmart is probably a business that has peaked without realizing it.

This is where the EDLC-EDLP model comes under heavy scrutiny and earns the kind of skepticism Bill Simon encountered in his analyst conversation from above. Traditional retail can grow comp sales through 1. pushing more volume through existing stores; or 2. raising the price on your stuff and earning higher margins.

Walmart's model mandates that it do everything it possibly can to avoid raising prices. (Indeed, former CEO David Glass has been quoted saying, "We want everybody to be selling the same stuff, and we want to compete on a price basis, and they will go broke five percent before we will.")  This avenue is effectively cut off to it.  So, that leaves us with increasing volume in the current store base. And that's the exact place Walmart has stumbled these past two years.  


And so we revisit the question: Is EDLC-EDLP a strength or a weakness? 

Before answering that, let me confess something. When I shop at a discount store, I shop at Target. This despite my admiration for the Walmart model and despite the fact that I am a Walmart investor. I explain it this way...

First, Target is in a much more convenient location to my home, and I am foremost a minion of convenience. It's a five minute drive away and happens to be in the same shopping center as my gym.

Second, I rarely have to fight for a close parking space, maneuver through aisles crowded with competing patrons, or wait more than a minute or two in a check-out lane.

And third, I'm relatively price insensitive to the items I normally purchase at a discount store and so am willing to pay a premium for the two set of conveniences noted above. And from my unscientific observations, Target sticks me with mark-ups on anything it knows I'll buy there rather than venture out on another shopping trip to a competitor. (For example, on a recent trip, I believe I got a fine deal on their diapers but also had to buy a bottle scrubber. I'm quite certain this item would cost $3 or $4 at Walmart. Target had three options for me, the cheapest of which was $11.)

My patronage must suggest Walmart's theme is flawed, right? Quite the opposite. To begin with, I'm not exactly Walmart's demographic. Looking at consumers today (and thinking about demographics of population growth), I believe people are getting more price sensitive, not less.

But more importantly, what might my observations suggest about Target versus Walmart? One, Target pays a premium to fit itself into an upscale shopping space near my neighborhood. It must cover that higher overhead. Two, the convenience I appreciate only occurs because this Target location drives far less customer traffic and so leaves open more parking spaces, generates fewer patrons in the aisles, and therefore doesn't have clogged check-out aisles.

When I do visit my local Walmart, it's further away, the price always seems low, and it's ALWAYS crowded. I have to wait in line for several minutes for check-out. As a customer, I dislike this. As an investor, I love it. Although anecdotal, it suggests to me Walmart maintains capital discipline...choosing to maximize traffic through its less expensive real estate before investing more to "fill-in" locations in more convenient locations.

How does Walmart get its customers to drive further, park further away, and wait longer in check-out lines?

EDLC-EDLP. Customers are price sensitive. As true as it was 10, 20, 30...50 years ago, there remains a draw to stores that offer the right selection at lower prices.

As long as Walmart maintains its edge, that ability to do EDLC-EDLP better than other traditional retailers (e.g., dollar stores, discount stores, consumer electronic stores, and grocery stores), offers consumable goods like groceries that bring customer in week-in, week-out (so they won't bring their other purchases to, and provides selection beyond what a warehouse club can offer at long as Walmart can execute this hard to replicate model, it will grow same store sales over the long run.

That being said, next we must consider how/why Walmart is a reasonably priced investment opportunity...