The True Value Ceators of the DJIA Part III
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In this third article in a series of five (the previous two are here and here), a closer look will be taken at Wal-Mart's (NYSE: WMT) higher-than-average residual earnings generation ability. As hypothesized in the series' first article, there appears to be a positive correlation between the active search for and purchase of firms that can consistently grow the earnings above and beyond their cost of capital, and long term investment returns.
To summarize the findings of the first article, four specific DJIA firms have been isolated -- Wal-Mart, Intel (NASDAQ: INTC), IBM (NYSE: IBM), and McDonald's (NYSE: MCD) -- based on their ability to grow residual earnings on common equity nearly seven times faster than the collective effort of the 30 DJIA firms over the past five years. Likewise, these firms also produced an average per share price appreciation of 13.5% per year since early January 2007, whereas an investor in the total DJIA would have essentially broken even over the same time period (-0.2% five year CAGR). Both of these figures examine per share price appreciations and do not include dividends.
As in the first two articles, the value creation framework illustrated below will be used to analyze Wal-Mart with hopes of isolating a unique, value-generating quality that is inherent in the firm's operations.
Note - Revisit the first two articles to review additional definitions/calculations that are not explained in the following discussion.
Over the five year test period, Wal-Mart's residual earnings grew at a compound annual rate of 14.2%, and an investment held in the corporation to date since early January 2007 would have yielded an average return of around 6.8% per year thus far (once again, no dividends).
As noted with Intel, Wal-Mart has been able to continuously grow residual earnings through the simultaneous improvement of the two primary drivers -- a growth in net assets (common equity balance) and its return generated on those net assets (ROCE). Once again, the improvement of several key business metrics acted to affect these drivers, but unlike Intel, Wal-Mart seems to have had a special "boost" that will be discussed further below.
Primary Residual Earnings Drivers
In examining the growth in Wal-Mart's residual earnings compared to its growth in ROCE and its equity balance, it can be determined that only around 12% of the change in residual earnings over the past five years was explained by the change in the corporation's net assets. Over the five year period, Wal-Mart's common equity balance increased from $61.6 billion to $68.5 billion, or about 2.7% per year.
This very small increase, which did not have an extremely large influence in the firm's residual earnings growth, was due to a slight growth in sales (five year CAGR of 4.9%), and the maintaining of a relatively stable average asset turnover level of 3.8 over the test period. These two factors were slightly offset by an increase in the firm's use of debt, as net financial obligations increased at a five year CAGR of 7.6%.
As the growth in the firm's shareholders' equity accounted for only about 12% of the change in its residual earnings, examining the return on those net assets (defined by ROCE) will isolate the core earnings drivers.
The improvement in ROCE is attributable to several key factors. First, unlike Intel, Wal-Mart's return on its core operating assets (RNOA) only increased slightly over the test period. Unfortunately, a large portion of the ROCE growth was attributable to a non-value creating, superficial boost from the use of leverage. Let's dig deeper.
First, the firm's return on net operating assets (RNOA, defined as post-tax operating income divided by net operating assets) of 15.7% in the fiscal year 2011 was within three-quarters of a percent of the firm's five year average. The firm's return on operations has been relatively stable over the long run, with the average ten year RNOA being a slightly lower 14.9%. The very small improvement has been minute increases in both asset turnover levels and margins (both gross and operating).
The other two drivers of ROCE growth -- financial leverage and the spread between RNOA and the firm's net borrowing cost -- were obviously the primary influence. Note - net borrowing cost is defined as post-tax interest expense divided by average net financial obligations (financial liabilities minus financial assets).
Because Wal-Mart's return on net operating assets was greater than its post-tax borrowing cost, it received a favorable leverage boost. For example, the RNOA of 15.7% in 2011 was "levered up" to yield a much more attractive ROCE of 23.6%. Over the five year period, the corporation's return on common equity was higher than its return on core net operating assets (ROCE > RNOA) by an average of 6% as a result of this increasing leverage boost.
The opposite "bad news" version of the leverage story could have taken place for a firm in which post-tax operating return fell below its net borrowing cost (still responsible for interest payments despite an operating loss). Even though this was not the case for Wal-Mart over the five year period, analysts of the company should be aware of the leverage boost and factor out its performance enhancement when examining the company's history. Over the study period, the residual earnings on common equity grew at a five year CAGR of 14.2% whereas the residual return on net operating assets only increased at an 8.8% CAGR. Although the company is still improving its core operations, projecting the higher and more attractive ROCE figure into the future would only present the risk of paying too much for the company's growth prospects.
The company also received a boost in its return on net operating assets through favorable operating liability leverage. Because operating liabilities reduce the net operating assets that the firm employs, the liabilities "lever up" the return on net operating assets. To the extent that Wal-Mart can get credit in its operations with no explicit interest expense, it reduces its investment in net operating assets and boosts its RNOA.
This effect is similar to what was discovered in the Intel case, and is something that investors should value. Over the past several years Wal-Mart's accounts payable balance has represented more than 90% of its large inventory balance. Effectively, the corporation is getting the large majority of this financed, over the short run, by its suppliers. This allows the corporation to untie funds from this portion of its operations and employ them to create additional value.
A similar case can be illustrated with Dell Inc. (NASDAQ: DELL) over its operating history -- the corporation was able to unlock additional shareholder value by exerting pressure on suppliers to carry inventory and delaying payments to suppliers. The corporation has also historically had a high accounts payable balance relative to its investment in inventory. This is a value creating activity, and Wal-Mart's operations are that much more valuable as a result.
With more than 8,300 stores constructed worldwide over the past 65 years, Wal-Mart, as the world's largest private employer, represents a success story that will not be outdone any time in the near future. The five year study on the corporation has shown that although Wal-Mart operates in the very fragmented consumer goods retail sector, it has still maintained very coveted and consistent growth over the recent past. What is even more positive to note is that this growth is in isolation from the favorable boost it receives from financially levering its operations.
Once again, and similar to Intel, the firm's ability to continuously grow its residual earnings appears to be attributable to a special franchise value that is of a rather intangible nature. The company has an unfathomably large moat protecting its operations, and through huge economies of scale and a large degree of customer captivity, the corporation's strong foundation in the retail sector can continue to produce above-average earnings even in a period of economic downturn. The Wal-Mart case has shown that it takes a special company that can take complete control of all facets of its business - sales, margins, assets, leverage, etc. - to consistently grow earnings above and beyond its cost of capital. As exemplified by the remaining DJIA firms not covered in this series, this is by no means an easy accomplishment for the average corporation.
There should be one last take-away from the leverage boost discussion. Prospective and current investors in the corporation would most likely avoid the risk of paying too much for Wal-Mart if they focused on the return on net operating assets (RNOA), as opposed to the artificially levered-up ROCE figure. Firms can create ROCE by borrowing, without any change in the profitability of their core operations. This is a non-value creating portion of growth that should not be paid for.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines, Intel, and McDonald's. Motley Fool newsletter services recommend Intel and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.