Figuring Out These Results Is Taxing Work
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When you are the world's largest anything, people are going to scrutinize your results. What most investors want to know is can this huge company continue to deliver good results, or is it about time for someone else to take over the top spot? Wal-Mart (NYSE: WMT) has been proving naysayers wrong for a long time by continuing to grow and expand. Decades after some investors thought the company had peaked; Wal-Mart still is finding ways to generate good returns for shareholders. The company's last earnings report seemingly was no different with earnings per share increasing an impressive 11.3%. However, if you dig a little deeper into the results, you'll see that there is at least one number that says Wal-Mart’s results were not as impressive as they first appear to be.
To say that the retail industry is undergoing major changes is an understatement. Companies like Amazon.com (NASDAQ: AMZN) are staking their claim to be the top retailer going forward by offering steep discounts, free shipping, and moving into new markets. Wal-Mart’s long time competitor Target (NYSE: TGT) will begin its international expansion with an entry into Canada this year. Costco (NASDAQ: COST) is constantly finding new ways to cut costs and innovate, and shoppers are being lured away from Wal-Mart’s “everyday low prices” by potentially even lower prices. No matter where you look there is competition, and over time the pressure for the world's largest retailer to perform will only intensify.
Wal-Mart is answering the call for good results, and though there are doubts about the holiday shopping season, the company's most recent quarter looked pretty good on the surface. Overall revenues increased by 3.4%, and if you exclude foreign currency, revenues would have increased 4.9%. Earnings per share increased 11.3%, and this was good enough to beat analysts’ expectations for the third consecutive quarter.
In the United States, Wal-Mart reported comparable store sales increased 1.5%, and operating income increased by 4.5%. Internationally, the company saw net sales increase by 2.4%, but without currency changes sales would have increased 7.6%. Operating income from the company's international division increased by 4.8%. The company's SAM's division saw strong sales as well, with comps. up 2.7% and operating income jumping 12.7%. If you just look at these results, the quarter looks okay, but this left me wondering how the company managed to report an over 11% increase in EPS?
One way that Wal-Mart increased their EPS was through share repurchases. While I prefer to see EPS increase from organic growth, a company that consistently buys back shares is almost as good. There are some companies that buy back shares solely to drive current quarter results, but Wal-Mart isn't one of these cases. The company consistently buys back shares so it's not as though management manipulated EPS to try and beat expectations for one quarter. With diluted shares down 2.28% year-over-year, Wal-Mart returned value to shareholders, and helped their EPS at the same time. In addition, the company generated 23.18% more operating cash flow in the last nine months compared to last year, and used this excess cash to improve their balance sheet. The company's cash is up by about $2 billion, and long-term debt dropped by over $5 billion compared to last year. It sounds like the company is firing on all cylinders, so what is my concern?
My big worry is that Wal-Mart saw an increase in EPS due to something that can't be counted on in the future. If you look at the company's core operating income, it increased 4.2%. This makes sense because Wal-Mart’s two largest divisions saw operating income increase by 4.5% and 4.8%. Considering some cost inflation, a 4.2% increase is reasonable. However, Wal-Mart’s lower tax provision led net income to rise 9.5%. This explains how the company was able to report an 11.3% increase in EPS. To be blunt, without this lower tax provision, Wal-Mart’s results wouldn't have been nearly as strong. Since it's unlikely that lower taxes will drive better results in the future, this is something investors need to keep a close eye on. If this one event was my only concern that would be one thing, but there are two other issues I'm keeping an eye on.
First, Wal-Mart’s foray into the grocery business is driving the company's gross margin down. This wouldn't be a huge concern, but when both Amazon and Target have higher gross margins I begin to worry. With Wal-Mart’s gross margin at 24.94% and Amazon at 25.26%, the online retailer is actually beating Wal-Mart at its own game. Target has always been seen as a more upscale version of Wal-Mart, and the company's 30.03% gross margin is much higher than Wal-Mart at the current time. Target is also moving into the grocery business, and my concern is the company's higher priced fashion and housing merchandise will hold Target's margins better than Wal-Mart. When you consider that Costco is growing by leaps and bounds and yet has a gross margin of just 12.66%, I can't help but wonder if this is where Wal-Mart’s gross margin is headed as grocery sales become more important. As you can see, with Costco running razor thin margins on the grocery side, Amazon offering convenience at a slightly higher margin, and Target taking fashion and home good sales, Wal-Mart is facing serious challenges in all of its businesses.
Wal-Mart has been on a nice run due to good results, but to my eyes it looks like the king of retail is getting tired. When you look at the other values in the sector, Target in particular looks like a better play. Target's P/E ratio is slightly lower than Wal-Mart at 12.01 versus 12.62. Target has a slightly higher yield at about 2.46% versus 2.34% at Wal-Mart. Target is also expected to grow earnings a good bit faster at 11.73% in the next five years versus 9.2% at Wal-Mart. When you consider Target has these three advantages, plus a higher gross margin, it makes it hard to recommend investors choose Wal-Mart over Target.
Amazon is very pricey, but is changing the game with its Amazon Prime service. This alone could challenge physical retailers to come up with unique offering, or risk being priced out of business. Costco seems like a safe bet to capture more of the grocery business, but at over 21 times projected earnings, the stock is much more expensive than Target, pays a lower yield, and both companies have similar growth profiles. In the end, Wal-Mart has been a great stock to own, but without some unique offerings, the king may lose his throne.
MHenage has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and Costco Wholesale. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!