Big Value in a Big Box

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There are some companies that defy categorization, and of these is a favorite of all-time value investors:  Wal-Mart (NYSE: WMT)Wal-Mart is a very hard company to describe; is it a discounter, a grocer, a drugstore, a financial services company, or a club store operator? The mega retailer from Bentonville, Arkansas seems to do all these things and a lot more.

One thing is certain; no matter what else it is, Wal-Mart is very, very profitable. As you can see below, the company has a quarterly gross profit margin of 25.75% in an industry notorious for its high costs and low profit margins.

The interesting thing is that Wal-Mart can maintain this kind of profit margin while constantly expanding into new business areas. The company is currently opening new smaller grocery stores in historically underserved urban areas. It is also offering a new prepaid debit card in cooperation with American Express (AXP) in another attempt to expand its financial services reach.

Normally, this kind of risk taking will have value investors dropping a stock like a hot potato, yet they line up to buy Wal-Mart because it has a lot of cash, and it is cash that makes Wal-Mart a true value play. In the period that ended on July 31, Wal-Mart earned $26.14 billion in cash from operations.

In contrast, Target (NYSE: TGT) generated just $5.56 billion in cash from operations, or about one fifth of Wal-Mart’s volume. Another value favorite, Costco (NASDAQ: COST)earned just $3.057 billion in cash from operations. All that risk taking has certainly paid off handsomely for Wal-Mart, but how long can the company’s luck hold out?

Longer than you might think, because of all the cash that Wal-Mart has to play with. Wal-Mart can afford to take some huge losses and maintain an earnings yield of 6.47%. As of July 31st, the company had $7.93 billion in cash and ST investments. Target had just $1.442 billion in cash on hand at the same time.

It is all that cash that allows Wal-Mart to take all those risks and get away with it. Wal-Mart can afford to open dozens of new grocery stores in saturated markets because of its cash. On the surface, this strategy might seem dangerous; Wal-Mart is planning to spend a lot of cash to open low-margin grocery stores in low-income urban and suburban areas. Yet when you dig deeper, you can begin to see the genius of Wal-Mart’s strategy.

Neighborhood Markets Expand Wal-Mart’s Reach

By opening all those new urban and suburban grocery stores, Wal-Mart gets an opening to sell all or a wide variety of its products to vast numbers of new customers. It also puts Wal-Mart in an excellent position to compete with a wide variety of retailers. If each of those neighborhood markets has a pharmacy, Wal-Mart will be in a position to compete directly with CVS Caremark (CVS) and Walgreen (WAG). Wal-Mart will be opening neighborhood pharmacies at a time when Obamacare is scheduled to put millions of more people on health insurance.

Wal-Mart will also be in a better position to deal with the threat posed by Family Dollar (FDO) and Dollar General (DG). Those companies operate neighborhood dollar stores that sell cleaning supplies and personal hygiene items. Wal-Mart has the volume to match their prices and offer groceries and prescriptions to boot. More importantly, Wal-Mart can now offer financial services such as the Bluebird card it and American Express have created directly to low income people in their neighborhoods.

The neighborhood markets can also help Wal-Mart cope with rising gas prices. Its customers won’t have to drive all the way to the supercenter, so they can shop at Wal-Mart without burning a lot of gas. The big threat Family Dollar, Walgreen and Dollar General pose to Wal-Mart is that they are often located right in the neighborhood. But Wal-Mart has now figured out how to enter the neighborhood. Even if people drive less because of high gas prices, they can still shop at Wal-Mart.

Wal-Mart has figured out what might be a successful long-term growth strategy for the North American market. Yet this strategy also raises an intriguing question for value investors. Can Wal-Mart generate enough cash from these neighborhood markets to maintain its high earnings per share and profit to equity ratios? Only time will tell, but historically, Wal-Mart has been able to generate large amounts of cash and high returns from questionable retail markets. If any retailer can make this neighborhood market strategy work, it is Wal-Mart. If the strategy works, Wal-Mart will be harder to define than ever because it will no longer be a big box.

 


StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend 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.If you have questions about this post or the Fool’s blog network, click here for information.

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