Wal-Mart: A Value For Shoppers, But What About Investors?

By Bobby Fisher - June 11, 2012 | Tickers: DG, KSS, TGT, WMT | 0 Comments

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Wal-Mart (NYSE: WMT) is the world’s largest retailer with sales in excess of $455 billion annually. On May 17^th, 2012 Wal-Mart announced its 1^st quarter performance with better than expected results.  Yet even this stalwart of U.S. and international retailing has faced scrutiny from major investment groups for recent allegations of bribery within its Mexican subsidiary Walmex (WALMEXV.MX).  Despite the negative press, Wal-Mart’s stock is currently trading near its 12-year high, which begs the question, does Wal-Mart still hold upside potential for investors or is the company fully valued.  

Current Situation

Wal-Mart reported 1^st quarter results above expectations with revenues in excess of $113 billion, an increase over the previous year of 8.5%. U. S. same store sales, an important indicator of a retailer’s health, grew by 2.6% from the previous year also ahead of guidance.  Operating income in real terms grew year-over-year by 8.3%, however in percentage terms gross profit margins of 5.65% were flat. Net income also grew year-over-year by 9.2%, and net margins in percentage terms grew by 5.46%.

Not so long ago some analysts had discredited Wal-Mart for shrinking net margins despite growing revenues and strong EPS results. This was in part due to increased sales in the low margin grocery business. Perhaps Wal-Mart has made some changes for the long-term to course correct their shrinking margins.  What is apparent is that Wal-Mart grew EPS from the previous year and came in above estimates again at $1.09 per share on estimate ranging from $1.01 to $1.06 a share, which I believe should make existing shareholders happy.

Earlier in April news erupted with reports of a bribery scandal where Wal-Mart executives in Mexico had repeatedly bribed local officials to obtain building permits and then tried to cover it up.  If the allegations are true, Wal-Mart may face serious punishment from the U.S. Department of Justice and Securities and Exchange Commission under the Foreign Corrupt Practices Act of 1977.  The effects of the news could also have negative impacts on Wal-Mart’s Mexican operations.  If the company was actually using bribes to hasten growth in Mexico, now the company would see a comparatively slower rate of new store openings.  Additionally fines from the DOJ and SEC could be as much as 1-2% of annual sales. For Wal-Mart, that equates to upwards of $4.55 billion if the allegations prove true.

Wal-Mart held its annual shareholders meeting and annual elections for the board of directors on June 1^st. Shareholders were quick to show their displeasure over the Mexican incident and challenged the current board leadership by voting against the re-election of the current CEO Mike Duke, former CEO H. Lee Scott,  Rob Walton (the son of Sam Walton) and Christopher Williams, head of the audit committee back to the board. The Walton family still owns approximately half of all outstanding shares in Wal-Mart so it was doubtful that outside investors would be able to overturn the board; however their votes were not insignificant. “No” votes accounted for approximately 30-35% of all votes made by outside ownership.

Competition

Target (NYSE: TGT) reported 1^st quarter results on May 16^th, the day before Wal-Mart.   Sales grew by 6.1% year-over-year and adjusted earnings were $1.11 per share, which was 11.5% over the previous year. Target, unlike Wal-Mart which has operations in 27 countries, currently only has retail operations in the U.S.  Target has plans to open stores in select cities in Canada, but that is not expected until 2013. Target has long been the up-market big box alternative to Wal-Mart, and there is a potential that once the U.S. economy starts a full recovery, more affluent shoppers will return to Target if they have not done so already. Amazon.com is another alternative for price conscious yet savvy shoppers, enabling them to price compare various goods before making a purchase decision.

The rate of domestic economic recovery is anyone’s guess. Economists’ estimates range from a recovery that has already occurred, to a full recovery that will take a full decade. Even as disposable incomes increase, consumers will likely continue to search for lower prices and continue to pay off debt. This should bode well for Wal-Mart domestically, but also for the dollar store chains which have grown over the past few years. While Wal-Mart has tried to attract more affluent shoppers, in doing so they may have alienated their core customer group. Once known for “Always Low Prices, Always”, Wal-Mart changed their slogan to “Save Money, Live Better” signaling a subtle shift in strategy. Dollar General (NYSE: DG) with its 9,000 retail locations became the low-cost alternative when Wal-Mart made this subtle shift. Dollar General has flourished during the economic downturn.  Over the past year, Dollar General’s stock has appreciated by 46%, from a share price of $32.25 at the beginning of June 2011, to over $47.00 recently.  The company also reported 1^st quarter earnings on June 4^th. First quarter sales grew by 13% year-over-year and earnings per share grew 40% to $0.63. In line with these increases, the company also increased fiscal year earnings guidance from $2.68 per share to $2.78.

Valuation

I estimated Wal-Mart’s equity value using a discounted cash flow model. Cash flows from operations were $27.7 billion over the last 12 months. As of 4/30/2012, Wal-Mart had approximately $48.8 billion of short and long term debt. Using a simple amortization of ten years, this reduces the available cash flow to $22.87 billion. Wal-Mart cannot maintain their brick and mortar operations without some investment in these facilities, so assuming these investments remain relatively flat from year to year I backed out property, plant and equipment investments from my estimates thus leaving available cash flow at $9.4 billion. This gives me a per share value of $2.69.  Even after applying a conservative discounting to this cash flow stream an investor is looking at a stock worth $68.70 a share. To support this estimate I assigned a price to earnings ratio of 15 to fiscal 2012 earnings and calculated a rough valuation of $68 a share.  Wal-Mart currently trades near its 12-year high of $65.50, which falls near my valuation. I believe the stock is currently trading close enough to fair value that investors should be wary. I would recommend waiting until the there is some deflation in the price before taking a long position. I believe that a 15% discount to my $68 price target is reasonable margin of safety, which gives me a target entry price of $57.80 or lower.

Alternative Investment

Consumers have been through the worst economic period since the Great Depression. Retailing in general lags economic movement, and as U.S. GDP creeps along other retailers are seeing modest improvements in sales as well. While Wal-Mart’s stock appears to be fully valued for investors looking to invest in the retail sector, I believe Kohl’s (NYSE: KSS) offers a more complying valuation story. Kohl’s, in my opinion, is one of the strongest positioned retail chains and should provide investors with significant upside potential. Kohl’s released 1^st quarter results on May 10^th. The company saw moderate growth of 1.9% in year-over-year sales and experienced a slight dip in gross margins which was expected due to a new lower pricing strategy. Kohl’s saw positive trends in same store sales and continued to open new stores during the quarter which it has done consistently throughout the economic downturn.  Kohl’s currently trades around $44 per share and in my opinion has a fair value closer to $50 a share.

Conclusion

Wal-Mart remains a giant in global retailing, but after nearly a decade of trading at below fair value, the company appears finally to be getting the respect it deserves from the market. Opportunities in the retail space continue and for the value investor, I would argue Kohl’s offers similar attractive valuation metrics as Wal-Mart did five years ago. 

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