Fellow GuruFocus contributor Grahamites wrote an article last week titled “Walmart and the Importance of Capacity to Reinvest” (here). As is always the case with Grahamites, the piece was well written and logical. However, for the sake of a spirited debate (and a differing point of view), I think it’s worthwhile to offer my rebuttal. As Grahamites notes, he believes Walmart (WMT) “lacks one important characteristic of a compounding machine – capacity to reinvest.”
When I first sat down to write this article, I planned on addressing some points that are relevant to that discussion; this includes what I perceive to be a justified slowdown in new International unit growth, investments in the ecommerce platform that are rolling through the income statement, the transition to Neighborhood Markets in the United States and the impact of M&A in the past few years.
But as I started thinking about those points, I came to the conclusion that this is secondary to the real issue; there’s one key sentence in Grahamites article that captures our difference in opinion:
“Walmart has been deploying capital in less efficient ways such as paying down debt and returning capital to shareholders.”
Let me start with some numbers: in the past five years (through fiscal 2015), Walmart generated more than $125 billion in cash flow from operations; roughly 50% was spent on capital expenditures. In that period, Walmart spent $36 billion on share repurchases, or nearly 30% of cash flow from operations – so of the remaining cash, the majority was used to buy back stock.
When Grahamites talks about “less efficient ways” of deploying capital, he is effectively saying that share repurchases are a less attractive use of capital than committing funds to capital expenditures. That is a fundamental difference in how we view capital allocation.
Let me clearly state my position: I don’t think building new stores is inherently better than repurchasing shares. In fact, I think a close look at Walmart’s international growth in recent years would provide a nice example of why new unit growth (whether organic or through M&A) is not inherently better than repurchases; you can look at Target’s (TGT) expansion into Canada if you would like an even clearer example of why capital expenditures alone do not ensure value creation.
Much like comparing the relative attractiveness of committing additional capital to either the ecommerce business or the International business, management should be considering the attractiveness of repurchases relative to alternative uses for cash flow. If they can do so cheaply enough, I believe they should even consider pulling back on stores that have attractive ROIs to fund even more attractive repurchases; all I care about is price relative to value.
This comment from Warren Buffett (Trades, Portfolio)’s 1999 shareholder letter hits the nail on the head:
“The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.”
When Walmart repurchases stock, they are reinvesting in the business; much like buying Yihaodian or Massmart, the attractiveness of that decision depends upon the price paid relative to the value of the asset received. Again, let me quote Warren Buffett (Trades, Portfolio) (1980):
“One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?”
The important caveat in that statement is “for far less than intrinsic value.” Depending on the price paid, repurchases can be worse, equal to or more attractive than alternative uses of capital (like M&A); there is nothing inherently better about one avenue relative to the others.
Unfortunately, and as I’ve noted in multiple articles, I don’t think most management teams think about repurchases in the context of price relative to intrinsic value. Instead, they simply view repurchases as a default/excess cash bucket in their capital allocation decisions. Buying for less than intrinsic value is the all-important hurdle that must be cleared; unfortunately, most companies are tripped up on this measure (in my opinion). They love to buy back shares when times are good (and prices are high), then hide under the covers (or lack the financial flexibility) to continue doing so when prices fall. The poor results that have been attained, on average, largely explains why repurchases are so often viewed in a negative light.
My personal opinion is that Walmart has a better record than most. I should also note that I’m encouraged by the early capital allocation decisions under Walmart’s CEO Doug McMillon. I think he is focused on the value of each dollar invested, regardless of whether it is being spent on building a new store or marginally increasing the remaining shareholder’s interest in the legacy assets (the commentary around the $20 billion repurchase authorization is worth rereading). He also has the benefit of running a business that consistently generates billions in excess cash, in addition to being less dependent upon the business cycle/overall economy than others.
But that’s not enough. Share repurchases face another big hurdle that management can’t do anything about: there’s no guarantee that Mr. Market will provide the opportunity to repurchase shares at a discount to intrinsic value. If years go by where management is unable/unwilling to repurchase shares because the valuation does not make sense, Walmart could end up having billions in excess cash lying around (or used in other ways, like repaying debt obligations); the short-term perspective of many shareholders and the analyst community makes it very difficult for managers to fight off the urge to do something, anything, with that excess cash (usually something stupid). Relative to capital expenditures, the window to intelligently repurchase shares can be fleeting; managers need a strong combination of both patience and conviction to act in size when they’re given the chance to do so.
Both of those points are important, and management needs to prove that it will act in the interest of the long-term owners of the business. It’s still early; time will tell if McMillon and Walmart’s new CFO Brett Biggs will succeed on this front.
Conclusion
Between ecommerce, Neighborhood Markets and the International business (though at a lower rate than what we’ve seen historically), I believe Walmart has plenty of opportunities to intelligently invest billions of dollars a year. Somewhere on the order of 40% of cash flow from operations will be used to fund capital expenditures in the coming years.
But the opportunity to intelligently allocate capital doesn’t end there: to the extent that Mr. Market is skeptical about the company’s future, Walmart may also have the chance to buy back a large number of shares at what may prove to be a sizable discount to intrinsic value.
As always, investors must decide whether management is intelligently allocating capital; this is true for capital expenditures and share repurchases alike. To the extent that intelligent decisions are made – whether on CapEx, M&A or repurchases – shareholders will benefit through sizable increases in per share intrinsic value. As long as Walmart’s management team remains focused on that metric, I don’t care how many additional stores they build in the coming decade.
