After 12 months, I ended 2013 without a single equity purchase – but I couldn’t make it through the first one in 2014! It’s tough to delineate why we act the way that we do sometimes (for example, would I have made this purchase if I had 2% of my funds in cash as opposed to about 20%?), but I think I’m making this investment with a clear focus on what matters most: buying at a discount to a conservative estimate of intrinsic value. I believe I’ve found a good business, with sound reinvestment prospects, a management team that has a proven track record (and a compensation structure that incentives a sound focus on shareholder interests), and a palatable valuation. With that, let me explain a bit further why I’ve purchased shares of Wal-Mart (WMT).
At the end of the most recent quarter, the company had 3.27 billion diluted shares outstanding; at $74 per share, the market capitalization comes to approximately $240 billion. Thirteen years ago, WMT shares traded just shy of their current level – the difference being that EPS has more than quadrupled since 2000. In the ensuing years, the stock has gone all of nowhere: The earnings multiple has contracted and contracted, a story familiar to many other companies over much of that period (JNJ, KO, etc.). I’m not making a bet on where the multiple will go next year – in fact, I would love to see it contract further; simply put, I believe that the implied returns (based on historical financials and conservative forward estimates) are well ahead of comparable alternatives like fixed income – significantly more than necessary to account for the added risk. On an absolute basis (the measure I’m most concerned with), I also believe the implied returns are satisfactory.
As I noted in my last article, the company’s financial performance has been amazingly consistent: operating margins have stuck in a 40 basis point range over the past decade, and the return on assets metric in any given year has never deviated by more than a single percentage point from the 10-year average. Sales per store in the United States have nearly doubled over the last 15 years, with the unit count increasing ~70% as well; Sam’s Club looks quite similar, with sales per club at ~$91 million from ~$46 million fifteen years ago, on top of 40% unit growth.
Grocery accounts for the majority of US sales, a category that the company didn’t participate in 25 years ago. In the most recent year, Wal-Mart’s grocery business was about ten times larger than Target’s (TGT); even before considering Sam’s Club, I estimate the company’s annual U.S. grocery sales are twice as large as Kroger’s (KR), the next closest competitor (after backing out fuel and pharmacy). Let’s focus on one category where size is a relevant competitive factor: as a Wall Street Journal article from 2011 noted, buying local is increasingly important in produce; beyond consumer preferences, companies have determined that trimming the number of “food miles” in an era of high diesel prices cuts fuel costs (like nearshoring in manufacturing), and also results in lower spoilage. By 2015, WMT hopes that ~10% of all fruit and vegetable purchases will be local; I think this trend will continue – and Wal-Mart should be able to win business from the largest, most efficient local producers over time. The cost benefits from this position (as opposed to cobbling together a network of smaller, less efficient producers) are likely to be material; that’s just one example of where scale can translate into a competitive advantage.
Many people believe that next frontier in grocery is ecommerce and delivery, but my personal opinion is that there’s still much work to be done on this front; the fact that Amazon (AMZN) Fresh costs $300 a year (or more than $5 per order for someone who normally shops once a week), before considering delivery charges on orders that don’t exceed a relatively steep limit, is telling. I personally believe that online plus in-store pickup may be an economically viable model for retailers, without charging fees that most consumers would consider exorbitant (Fresh is 3X more expensive than a Netflix subscription); Wal-Mart clearly has a solid starting position if that's where we're heading, and they’re actively testing the concept in Denver as we speak. The company’s plan to expand their network of smaller format stores in the US will help move them another step ahead of the competition.
I won't talk much about e-commerce, other than to rehash what I discussed a few weeks ago (here). Wal-Mart’s e-commerce sales are expected to have crossed $10 billion this past year (+30% year over year), on their way to more than $13 billion next year (good for another year of 30% growth). In a recent interview with the Wall Street Journal, Wal-Mart’s head of e-commerce said the following: "This is not a side project; this is how we will be serving customers going forward." He also noted that Wal-Mart will be able to match Amazon’s range of products and shipping times in the next twenty-four months – in addition to a mix of online and brick and mortar transactions and delivery options that Amazon simply cannot match (like the grocery options discussed above). Wal-Mart recognizes the threat from Amazon, and is devoting significant financial resources to competing with the juggernaut (most of which flow through the income statement in the year incurred as expenses). At the same time, the company realizes they can do many things with their retail footprint that Amazon cannot. This fight will continue for many years, and it isn’t winner takes all; with that said, I think Wal-Mart holds an enviable hand.
Over the past decade, the company has returned ~70% of earnings (on average) to shareholders via dividends and repurchases; at a going-in earnings yield north of 7%, this would suggest a “shareholder yield” – accounting for dividends and repurchases as a percentage of the current market cap – around 5%. The remaining 30% of earnings ($5B+) are retained and reinvested back into the business, along with the additional debt that this new level of equity can sustain (the company has historically run around 2.5x on this measure, comparable to where it currently stands). All in, that’s a nice starting yield plus significant reinvestment in growth as a kicker.
In the past few years, Wal-Mart has only been able to squeeze out a few points of revenue growth (average of 5% since fiscal 2008), all of which has come from new stores; while sales per U.S. unit have increased over that time period (albeit slightly), sales per international store have cratered – they’re 25% below where they came in six years ago. International units grew single digits in FY13, the first time that metric hasn’t been in the double digits in a decade; the fact that management recently cut the FY15 International CapEx target by $500M is a telling sign that the slowdown in FY13 will not be a one-off event. I think this is justified by the numbers; until the results start to look more like FY05-FY07, throwing good money after bad isn’t the answer.
As always, there’s two sides to the story – and while International has struggled, the beauty of such an outcome is that it creates some optionality in the stock; unless you think stores outside of the U.S. are heading to zero, one must ask when the slide will either slowdown or reverse – as well as what that outcome would mean for the company as a whole. Management will require International to pull its weight, or capital will be spent elsewhere (the fact that the NEO’s derive 50% of their long term equity compensation based on ROI assures that management will keep this in mind); as an investor, I think that’s the right approach to take – I’m more than happy with repurchases that increase my ownership of the current retail footprint at reasonable valuations as opposed to top line growth from less attractive per unit economics.
A tough holiday for retailers has spilled over into the New Year: ShopperTrack estimates that retail sales increased 2.7% in January, compared to the 4.4% average increase in 2012 & 2013. The Dow was down more than 7% through February 3rd, with the SPDR S&P Retail ETF down more than 12% over that same period; there’s blood in the streets – and as a value investor, that’s what I love to see (WMT fell a little over 5% in January, with a current market cap of ~$240 billion). I would be quite happy to see another 5% decline next month, if Mr. Market were feeling so kind (he lopped off another 2.7% on day one).
For the trailing year, management expects earnings of ~$5.10 per share (the company will report on February 20th); after making some adjustments (again, see my prior article), I estimate owner’s earnings is closer to $5.80 per share. At $74 per share, the stock is trading for less than 13X owner’s earnings; with a 10% discount rate, a reverse DCF model from the current stock price implies terminal growth of ~3% per annum. For the sake of a reference point, diluted EPS has increased 11% per annum over the past decade; even in the five year period ending in fiscal 2009 (when operating margins and ROA touched their lowest point since the turn of the century), earnings per share still increased at 7% per annum. While domestic comps have struggled as of late (they’ve been in negative territory for all of FY14, after trailing lower every quarter through FY13), the 10-year trailing average was +2.3% per annum; that’s the long way of saying that I think 3% per annum will prove to be pretty darn pessimistic in hindsight, as has started to happen with J&J in the past few quarters (investors who bought when Mr. Market only saw trouble for JNJ in 2011 and early 2012 are currently sitting on unrealized gains of ~50% or so, before dividends).
To reiterate what I said above, I like this valuation compared with other alternatives; I believe that investors are likely to generate all-in returns at or above 10% per annum from current levels over a reasonable holding period (5-10 years). Compared to a ten year treasury yield around 2.6%, that sounds pretty good; looking at other equity investments, I think that same conclusion still holds. However, I’m not going crazy here; while 10% sounds pretty good by comparison, that’s the low end of what I’m happy with on an absolute basis – and that’s the lens I view potential investments through. Some quick math would show that if I think the current valuation ($74) is good for 10% per annum (including dividends), under $67 is the level where that metric moves north of 12% (using a 5-year holding period). If we get back to the mid-60’s (where the stock traded back in 2012), I’ll start adding to the position more aggressively (currently it’s ~3% of my portfolio; that’s generally the smallest increment I move in). The lower we go, the more I’ll buy.
As always, I’m interested in hearing what others think. I tried to keep this article as short as possible while still hitting the key points; if there’s something you would like to discuss further (or something that you think I’m missing), please let me know!
About the author:
I run a fairly concentrated portfolio by most standards. My three largest positions generally account for the majority of my equity portfolio. From the perspective of a businessman, I believe this is more than sufficient diversification.