Down More Than 15%, Wal-Mart is Still Too Expensive
I’ve made my bearish sentiment surrounding the traditional brick and mortar retail sector no secret over the years. Early on in my investing career I owned stock of the big box big boys: Wal-Mart (WMT) and Target (TGT). I’ve owned shares of high flyer Home Depot (HD), recently bought out Whole Foods Market, and grocery store giant Kroger (KR), as well. I bought shares of these companies because I believed that their dividends were strong and reliable. I didn’t put much stock into disruptive threats on the horizon.
It took years for me to buy into the Amazon blueprint, but once I did, I realized that all brick and mortar companies were in trouble. Since then, I’ve drastically shifted my equity exposure within the the retail space to reflect this concern. I’ve sold out of the big box operators and Amazon has become a top 10 holding for me, representing more than 2% of my overall portfolio. More recently, I’ve added to my eCommerce exposure with Chinese powerhouses, Alibaba (BABA) and JD.com (JD). I couldn’t be happier with the returns that these moves have produced for my portfolio over the last couple of years and moving forward, I sleep well at night knowing that I have exposure to some of the worlds fastest growers and most adept disrupters.
With this being said, I’d be lying if I said that I wasn’t eating a bit of crow over the last couple of years as Wal-Mart ran up from its late 2015 lows in the $50 range to its recent high of $109.98 in late January. Frankly put, I underestimated Wal-Mart’s ability to make headway in the eCommerce space. WMT’s Jet.com acquisition alongside its already robust logistics operations is proving to be more of a force in the online retail competition than I ever imagined. I have to give kudos to WMT management for their willingness to evolve with the times and attempt to compete with Amazon (which is something that very few businesses can say that they’ve done successfully).
I suppose I shouldn’t have been surprised. Wal-Mart is the world’s largest retailer, after all. WMT has generated nearly half a trillion dollars of revenue over the trailing 12 months. This is an amazing feat. However, as astounding as these sales figures are, it’s not the revenue in the present that matters, but instead its growth rate and the company’s forward looking prospects.
WMT produced same store sale growth of 2.6% in the company’s most recent quarter. This is solid, especially when you’re talking about such a large base. However, low-mid single digit sales growth shouldn’t result in a growth premium on shares.
WMT is guiding for $4.75-$5.00 of EPS during FY19, meaning that shares are currently trading for an 18.75x forward looking premium. This is well above WMT’s historical norm. Prior to the company’s aforementioned run-up during 2017 and 2018, Wal-Mart shares typically ran into resistance in the 16x range since coming out of the Great Recession in 2009. As you can see on the F.A.S.T. Graph below, WMT did break above this resistance in late 2014 when it traded up to ~17.5x earnings, but this move resulted in a precipitous sell-off, from $87 down to $58 during the ensuing 10 months.
I not going to attempt to predict the future, so take this next bit with a grain of salt, but I wouldn’t be surprised if this recent bout of overzealousness by the market will result in another steep sell-off as investors realize that while Wal-Mart is a wonderful company, its growth simply doesn’t justify the prices that investors have been paying. I think Wal-Mart’s fair value is in the 15x area with regard to forward multiples, meaning that share would have to fall another $15 or so, representing another 16% to the downside.
Now, don’t get me wrong, I’m impressed with the strong double digit growth that WMT’s eCommerce segment has produced year over year. Management is expecting eCommerce sales to increase another 40% or so in FY19; however, it’s also worth noting that WMT’s online sales are still so small relative to the $500b of total sales that they shouldn’t really move the needle much.
That 2.6% same store sales growth is a much better measurement of top-line growth for WMT and will continue to be for the foreseeable future. Considering the fact that the online sales that represent WMT’s growth market represent less than 5% of the company’s overall business, I can’t help but wonder if much of the positive sentiment surrounding WMT’s growth potential has been misplaced. And surely they’re not going to be impactful enough in the near-term to justify a ~33% increase in premium (from ~15x to 20x earnings).
What’s more, the investor focus on online sales are a bit of a catch-22 for the company because while WMT needs to compete with AMZN by taking online market share, online sales are more expensive to make when you factor in shipping and produce much lower margins than physical retail sales. In other words, WMT is being forced to make “price investments” as management so eloquently spun it during the recent conference call. In other words, Wal-Mart is forced to offer deeper discounts to compete and this isn’t a trend that WMT investors should want to see continue.
These “price investments” led to a consolidated gross profit margin decline of 61 basis points in the recent quarter. These lower margins and disappointing eCommerce guidance were major factors in the stocks recent sell-off. The single day double digit post earnings that WMT experienced earlier in the week was its worst trading day since 1988. Surely, the market is realizing its folly.
For WMT to compete in the eCommerce arena, investors must be willing to accept lower margins. This race to the bottom online might actually put pressure on the more important same store sales growth moving forward as well because of its deflationary nature. This puts WMT management in a tricky position and I think investors are starting to realize that maybe taking market share in the eCommerce wars against AMZN, a company that isn’t so concerned with the bottom-line (and is lucky enough to have a shareholder base that allows such slim margin performance), won’t be the saving grace for this company that they thought it might.
Wal-Mart certainly has the cash flows and the logistics infrastructure in place to compete with Amazon if its wants to, and maybe it has to, but I have a really hard time imaging this being a boon for margins. Sure, sales will increase and maybe profits along with them, but narrow profit margins equate to narrow moats/margins of safety.
Although I’m long AMZN, I admit that the company has an irrationally high valuation premium. This is because of Jeff Bezos’ unmatched salesmanship as well as the company’s long-term oriented, diversified business model. Wal-Mart isn’t nearly as diversified as Amazon. WMT doesn’t have a leading cloud platform, it isn’t a leading company in the AI space, it doesn’t have a diversified consumer ecosystem (Amazon Prime offers music and video alongside its online shopping experience), and while it is surely increasing its technological prowess, WMT certainly doesn’t have the same talent as AMZN in the tech space. All of this points towards the fact that WMT won’t be the disruptive growth force that Amazon has been and therefore, doesn’t deserve a similar long-term growth oriented premium.
I’m keeping a close eye on WMT shares as they fall (as I write they’re down more than 15.5% from recent 52-week high), but I’m still not attracted to the company of a fundamental valuation level. WMT’s success in the online retail space has convinced me that it is a worthy company to own once again, though only at the right valuation. While I’ve changed my tune on WMT because of its online execution, I’m certainly not willing to pay a premium for shares. At $75 I would likely be interested in initiating new exposure.
A $75 share price would represent a ~2.75% yield. When I sold my WMT shares a few years back I cited the fact that they weren’t growing their dividend well enough for me to hold on. WMT has given investors a 2% annual increase for four consecutive years now. Prior to this new, low single digit trend, WMT habitually rewarded investors with strong, double digit increases. I understand that the company is in a strong internal investment cycle as it attempts to compete in the volatile retail space, but even if these investments are warranted, I still expect mid-high single digit growth from a dividend in the 3% area. I expect double digit annual growth from a dividend in the 2.5% or less area, meaning that from a dividend growth standpoint, WMT is not up to par.
Source: F.A.S.T. Graphs
If/when I see this dividend growth trend change, I will become much more bullish on shares and be willing to place a slightly higher premium on them. At the end of the day, a mature company like WMT is an income play for me, not a growth vehicle. I buy disruptive technology names when I’m looking for growth and I buy mature, cash cow companies with histories of generous shareholder returns when I’m looking for defensive, reliable additions to my passive income stream. Right now, WMT decidedly falls into the latter group here, though with a bit of a hybrid growth kicker with regard to its eCommerce business (it’s also worth noting that WMT owns a significant stake in Chinese eCommerce giant, JD.com and has an ongoing partnership with them that does make me more bullish on their international growth prospects).
Now that Wal-Mart is out of the penalty box, I’m just waiting for the market to give me an attractive opportunity to buy. Time will tell if that happens or not, but in the meantime, I am happy to watch and wait, holding the true growth names in the retail space: Amazon, Alibaba, and JD.com.
disclosure: I am long AMZN, BABA, JD, and KR.