Wal-Mart Poised for Short Term Pause and Long Term Gains
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Wal-Mart Stores Inc. (NYSE: WMT) has seen its shares rise almost 37% over the past 12 months. During this stretch, the trailing P/E ratio has expanded from under 12x to more than 15x. This expansion of the multiple is a reversal from a trend that saw the multiple move steadily downward from a peak of 29x during 2002 to about 12x during 2011, averaging about 18.8x over that timespan. Relative to the broader market multiple, Wal-Mart's multiple of 29x in 2002 was about 1.5x the S&P 500 multiple of about 20x. This ratio of Wal-Mart’s PE to the S&P 500 PE reached a low point at 0.85x in 2009 and has recovered to about 1x currently based on Wal-Mart’s price to earnings multiple of 15.7x and the S&P 500 multiple at 15.2x.
Although Wal-Mart’s PE multiple shrunk from 2001 through 2011, the company increased cash flow from operations and free cash flow annually by about 9.0% and 19.1%, respectively, during that time. Wal-Mart has achieved the free cash flow growth by growing earnings per share by about 11.7% and revenue by about 7.4% annually since 2002. However, analysts are projecting slower growth with earnings per share expected to grow by only 9.4% in fiscal 2012 (ended January 2013) and by 9.0% in 2013 while revenue is forecast to increase by only 6.2% in 2012 and by 4.8% in 2013. This slower growth will make it more difficult for the company’s shares to continue their multiple expansion relative to the S&P 500 beyond the current 1.0x ratio as current estimates for the S&P 500 call for growth in earnings of 7%-12% for 2012 and 2013.
Wal-Mart’s earnings and cash flow growth reflects the company's ability to improve efficiency as it has increased its return on equity to about 25% in 2011 from an average of about 21.2% over the past decade and 20% in 2002. Likewise, return on invested capital has been raised to about 13.3% in 2011 from about 12.1% in 2002 and an average over the past decade of about 12.9%.
Three strategies that the company is executing are the basis for reviving profits and cash flow growth which has prompted the PE multiple expansion. First, due to returns on investment that are expected to exceed returns on traditional bricks & mortar stores, Wal-Mart is entering the e-commerce area. Next, its international segment is gaining critical mass and the company expects the segment to contribute materially to overall profit margin expansion and return on invested capital. Lastly, the company has introduced its Wal-Mart Express format targeting underpenetrated urban and small rural markets that it sees as an opportunity to capture domestic market share.
Risks which might derail the creation of value by these strategic choices include: poor execution of the e-commerce initiative which would generate sub par returns and could even destroy intrinsic value if traditional sales are cannibalized; the company has not proven it is able to compete effectively in the international segment even though they have been engaged for about a decade in some markets; and the company is now facing a domestic competitive landscape including chain grocery stores such as Costco Wholesale Corp. (NASDAQ: COST) and deep discount stores such as Dollar General Corporation (NYSE: DG) and Dollar Tree Inc. (NASDAQ: DLTR) that are much larger and more aggressive than the "mom and pop" retailers that were formerly Wal-Mart's primary competition. Costco shares have risen by more than 21% in the past year while Dollar General’s shares have rocketed up by more than 63% and Dollar Tree’s shares are up almost 57%. Currently, Costco has a forward PE of 22x-25x for 2012 and 2013, Dollar General trades at a forward PE of 16x-19x for 2012 and 2013 and Dollar Tree trades at 19x-21x 2012 and 2013 EPS estimates.
Wal-Mart has been a stellar performer over the past 12 months with a total return approaching 40% when the dividend yield, currently at 2.2%, is included. Because this performance has not been accompanied by a corresponding rise in earnings, the company’s PE multiple has expanded both in absolute terms, from 12x to more than 15x, and also relative to the S&P 500 multiple. While I believe that the company’s strategic initiatives, particularly international expansion, will be largely effective in creating shareholder value, at this point shares are more likely to take a rest at the current share price than to continue their steep upward trajectory. However, long term investors willing to be patient and accept the dividend yield, currently at 2.2%, should be rewarded with outsize returns relative to the broader market as earnings and the PE multiple continue to grow faster than the S&P 500 index.
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