Everyday Low Prices, Everyday Low Returns

By Michael Finarelli - February 13, 2012 | Tickers: COST, TGT, KR, WMT | 0 Comments

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When it comes to the financial markets, there’s something that’s so alluring about growth for both individual and institutional investors alike. Whether its growth in sales, growth in earnings, growth in store units (the list goes on and on). Clearly, we live in a society that craves and rewards this notion of having more.  Even in the corporate setting, managers often fall prey to this desire as they make strategic decisions designed to keep the top line growing at a healthy clip. Case in point, one need not look far past their domestic market to find large multi-national corporations desperately trying to tap foreign engines of growth, today’s emerging markets. Although this decision to enter large, often fragmented markets to expand the customer base seems like a no-brainer on the surface, the heart of the issue is whether or not this growth is truly profitable. Such is the question I pose when examining the global expansion strategy of the behemoth discount retailer, Wal-Mart (NYSE: WMT).

Wal-Mart grew from humble beginnings in 1962 to become the world’s largest retail corporation in the world today with 2011 sales of $419 billion spread over 9,700 retail stores. Its rise to prominence grew in part to its ability to undercut its competitor’s markups enough to drive increased sales.  As Wal-Mart grew, it leveraged its enormous operating efficiency, logistical power, and inventory tracking might to run many a mom-and-pop retailer out of business.  And loyal shareholders were rewarded handsomely. In fact, in the 20 year period from Wal-Mart’s trading debut in the early 1970’s until it’s first business dabbling in overseas markets, Wal-Mart shares have grown at a compounded rate of 32% per annum compared to the approximate 7.2% compounded return of the S&P500. (Yahoo Finance – Historical Prices)

All Good Things Come to an End

However, as is always the case, at some point in the history of all large multi-nationals, domestic markets become saturated and top line growth begins to slow.  Here comes the typical inflection point of most large publicly traded companies as they seek to re-ignite what seemingly everyone desires: the beloved growth rate. How do these companies who have risen to the pinnacle of their respective industries’ domestic markets plan to woo back Wall Street you ask? Simple, by setting out to conquer the rest of the world! At least this seems to be Wal-Mart’s plan since the early 90’s.  

All Growth is Not Created Equal

The real truth behind growth is that not all growth is profitable. Only growth that earns returns above the cost to employ that capital is profitable growth and thereby adds value to the firm. Everything that falls short of the cost actually destroys value despite the increase in size. The chart below shows Wal-Mart’s return on invested capital on a segment basis.

Wal-Mart has three distinct segments: Its US operations, International operations, and Sam’s Clubs.  As one can plainly see the same profitability that drove Wal-Mart in its early years to huge success is still alive and well in its domestic US stores. Even the warehouse model of Sam’s Club generates an attractive return, likely above the cost. However, the same cannot be said for the International unit.  At these anemic returns, it is likely that Wal-Mart’s heavy investment overseas is eroding shareholder value over time.

Since Wal-Mart’s first foray into non-US markets in 1991, the company has poured billions into the high growth emerging markets.  As of the fiscal 2011 year end, the international unit generated over $109 billion in revenues, which accounts for roughly 26% of total sales.  On the surface it would seem as though Wal-Mart had tremendous growth potential abroad. However, the international unit lacks the same profitability as its domestic counterpart. This is evidenced by the smaller proportion of the international segment’s operating income to the total, roughly  20%. (Wal-Mart’s 2011 Annual Report). This disparity remains despite the fact that the International segment accounts for nearly 50% of total store units, a relationship that further explains the results of the chart above.

Today, Wal-mart continues to set its sights abroad as it expands rapidly into Brazil, China, and its newest frontier, India.  The companies 2010 majority purchase of MassMart also gave it a sizable presence in South Africa as well as an avenue for future growth in Africa’s less developed regions.  But, this hasn’t been a story of perfect conquest.  Wal-mart has certainly had its share of failings. Consider the fact that the company pulled completely out of Germany and South Korea in 2006 due to mounting losses amid tough competition. Here resides an important point: The same business model that worked well at home may not pan out abroad where differences in culture, consumer preferences, economies, political and regulatory systems, as well as labor practices abound. Perhaps this explains Wal-mart’s strategy of acquiring or partnering with established local competitors in certain markets.  Although this may help alleviate some of these issues, the value created for shareholders depends squarely upon how much Wal-Mart spends to buy these foreign rivals.  Tying back into those paltry ROIC figures that belong to the International segment, if Wal-Mart spends too much relative to the earnings potential of these businesses, then shareholder value will surely erode.

Wal-Mart’s early success here in the US was a function of the high returns that the domestic business earned. In other words, rapid growth early on was highly profitable for shareholders. But, today’s emerging markets are not the same as the typical small US towns that were overtaken by Wal-Mart over the past 40 years. Although highly fragmented, today’s emerging markets are entrenched with more formidable competitors including the likes of France’s Carrefour, Brazil’s Grupo  Pao de Acucar, and China’s Shanghai Bailian to name a few.  In some instances these competitors may be better positioned to lure additional market share than good old Wally World; yet another source of the company’s stubbornly low returns. Some argue that it is necessary to subsidize this low return international growth with strong profits from domestic operations in order to gain a so called first mover advantage in these vast markets seemingly ripe with opportunity. However, I offer this as a perspective: If you think about the basic calculation for determining an annualized return, one understands that a longer time frame for the investment to pay out reduces the return that the company experiences on that capital. So while it seems like a good idea to get more skin in the game of the emerging markets, if those profits are too low for too long, then the return on that capital eventually falls to unattractive levels. At this point, shareholders essentially entrust management with their capital to earn less than mediocre returns.  Rather, if shareholders could earn a better return elsewhere, wouldn’t it make more sense to return that same capital to shareholders either in the form of increased dividends or share repurchases?

Warren Buffet often refers to the Institutional Imperative, a lemming-like behavior characterized by a follow the crowd mentality. If all of the major retailers are rushing to expand overseas, shouldn’t we join in to grab our share as well? With that in mind, I thought it might be interesting to see how some of Wal-Mart’s top US competitors stack up.  As a direct competitor to the Sam’s Club model, Warehouse retail operator Costco (NASDAQ: COST) has been somewhat of a late bloomer in its overseas expansion given the fact that they only began to move outside of their domestic borders within the last decade. Today, though, Costco operates 163 stores abroad, mostly in Canada, Mexico, and The U.K.  Target (NYSE: TGT), the general merchandise retailer known for their higher quality offerings relative to Wal-Mart here in the US, has interestingly resisted the institutional imperative until recently with their planned expansion into Canada via a $1.85 billion dollar deal to acquire leasing interests in the struggling retail chain Zellers.  Competing with Wal-Mart primarily on the grocery retail front, Kroger Co. (NYSE: KR) continues to avoid the ‘imperative’ even today as its operations are derived completely from its home market, the U.S.

Although some retail operators have bucked the globalization trend, it appears that for at least some the race to global domination is alive and well. But will management’s desire to build a global empire translate to outsized shareholder returns?  For me, I still believe that continuing to pump money into low return investments overseas is arguably the best and possibly least detected way to destroy value.

 (ROIC data was obtained from Wal-mart's 10Q's. The ROIC calculations above are defined as NOPAT/Invested Capital. NOPAT is derived from the Operating Income line on the Income Statement and then adjusted for cash taxes at the applicable rate. Invested Capital is derived by taking the Total Assets line on the Balance Sheet, then subtracting Non-Interest Bearing Liabilities and excess cash. Current Liabilities were used as a proxy for non interest bearing liabilities, and excess cash was not considered since the estimated amount relative to total assets for Wal-mart is immaterial).

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