Walmart (WMT, Financial) is owned by many value investors, or at least has been on many value investor’s target list. I’ve followed Walmart, studied the history of the business as well as the stock and admired Sam Walton for what he achieved. At this point, while the stock looks cheap, it lacks one important characteristic of a compounding machine – capacity to reinvest. In my previous article, I posted my notes on Chuck Akre (Trades, Portfolio)’s interview on Wealth Track where he talked about what he calls the compounding machines. When answering the question of why not favor dividends-paying companies, Akre offered the following insight:
“Our goal is to compound our capital. There is no free lunch. Management only has three to four choices to do with all the free cash they generate. They can pay dividends, they can buy back stocks, they can invest back in the business or they can acquire other business. In order to compound their capital, the most efficient way is to invest in their own business or other businesses where they earn above average rate of return. If they pay dividends, they no longer have the dividend to do that. So it’s a marginally less efficient way for us to compound our capital.”
He then talked about the requirements of a great business:
“The requirement for a great business for us has three components. First of all, we spend a lot of time trying to understand what’s causing this above average rate of return to occur. Is it getting better or worse? Secondly, we want to see a shareholder friendly management. Lastly, we look for a history of reinvesting the free cash flow as well as the opportunities to reinvest the free cash flow at above average rates. None of these is constant. Business models get better or worse. People’s behavior changes from time to time. The ability to reinvest varies from time to time.”
Walmart almost passes all the requirements. The company earns a very high return on equity, has a shareholder-friendly management and has a history of reinvesting the free cash flow. However, it lacks the most important ingredients of a compounding machine – the opportunity to reinvest the free cash flow at above average rates.
How do I know that? This is not perfect but a very simple yet effective way is to look at the statement of cash flows. Fifteen years ago, Walmart generated $9.6 billion operating cash flows that it can redeploy. Of this $9.6 billion, Walmart reinvested $8 billion, or almost 85%, in the business and returned only $1.2 billion, or 13%, to shareholders through dividends and share repurchases. For the next few years until 2007, Walmart was able to reinvest most of the operating cash flows in the business and generate higher than average returns.
Things started to change in 2008 when Walmart only reinvested 70% of the operating cash flow in the business and returned the rest to the shareholders through dividends and share repurchases. The reinvest ratio has steadily declined from 85% in 2001 to 70% in 2007 and only 43% in 2015. Meanwhile, Walmart has been deploying capital in less efficient ways such as paying down debt and returning capital to shareholders. For instance, in 2011, Walmart returned a whopping $19 billion or almost 80% of operating cash flow to shareholders. In 2014, Walmart returned $13 billion, or almost 55%, of operating cash flow to shareholders.
With the reinvesting opportunities between 2001 and 2007 came faster revenue growth, earnings growth and the compounding of shareholders equity. Walmart revenue almost doubled and earnings more than tripled during those years. The lack of reinvesting opportunities since 2007 coincides with the much slower revenue growth and earnings growth, which ultimately translated into slower compounding of shareholders’ capital.
Some may cheer for Walmart’s management decision to return a massive amount of capital to shareholders and argue that it deserves a higher valuation. I think as long as the lack of reinvesting opportunities exists, Walmart deserves a low multiple.
I am not saying that Walmart is not a good investment from here. The risk of permanent loss of capital is low and the dividend yield may be attractive to income seekers. Personally I am much more willing to invest in businesses with higher multiples, lower dividend yield and much better reinvestment opportunities. In the future, Walmart may become a compounding machine again when it finds a way to rekindle its capacity to reinvest.
