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The Science of Hitting
The Science of Hitting
Articles (438) 

Revisiting My Walmart Thesis

After 3 years, it's time to review my decision making

I started writing articles about Walmart (WMT) in early 2014. I disclosed my initial investment in the company shortly thereafter (link). In the three years since that was published, Walmart stock has treaded water. Relative to the Standard & Poor's 500, which has increased by ~30% over the same period, this investment has performed quite poorly.

Personally, I’m less concerned with the price performance of a stock (particularly over a few years) than I am with the quality of the decision-making that led to the investment (process over outcomes). This article will revisit the thesis published in February 2014 to determine if errors in my analysis explain the poor returns reported thus far.

Rather than rehash the entire article, I’ll copy and post key sections that are worth discussing; if you’re interested in more detail, I encourage you to read the original 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.”

Well that was good timing! After a decade in a tight range (between 5.6% and 6.1%), operating margins declined significantly in fiscal 2016 (to 5.0%). This trend has continued, with fiscal 2017 operating margins falling to 4.7%. This is more than one hundred basis points shy of the trailing 10-year average. Over the past two years, margin compression alone has driven a mid-teens reduction in Walmart’s operating income – the primary driver behind the 13% drop in EPS reported over the same period.

But what happened isn’t all that matters; it’s also important to understand why it happened.

Walmart is in the middle of significant investments in its people and its ecommerce business. The question is whether these investments make economic sense long term. Let’s look at them individually so we can try and understand what impact they’re having on the business (if any).

The investment in the company’s employees, which includes higher wages and better training, has come at a cumulative cost of $2.7 billion per year (call it 50 basis points). Management has argued that this decision was necessary to find and retain high-quality people; it’s a necessary step to improve in-stock levels, store cleanliness, customer service and so on. While it’s only been a few quarters, it appears that these investments are starting to pay dividends: Comp store sales in the most recent quarter were the highest they’ve been in four years (despite the meaningful headwind from food cost deflation). Management deserves some credit for the results it has delivered in the current environment, particularly relative to other brick-and-mortar retailers.

Walmart’s e-commerce business is showing signs of life as well, particularly in the United States: sales in the fourth quarter increased by more than 25%. As I noted back in August (link), the decision to hire Marc Lore, who joined via the Jet.com acquisition, is a big bet by Doug McMillon. I’m excited by this development, but my expectations remain tempered. While I hope Walmart will find a way to more effectively compete online, my conclusion from the past few years is that they have little chance of standing toe-to-toe with Amazon (AMZN). In October 2015, management projected that e-commerce operating losses would bottom in fiscal 2016; that almost certainly didn’t happen. While it’s more difficult to quantify than higher wages, continued e-commerce losses have been detrimental to Walmart’s margins as well.

“Many people believe that next frontier in grocery is ecommerce and delivery, but my opinion is that there’s still much work to be done on this front. Online plus in-store pickup may be an economically viable model for retailers, without charging fees that most consumers would consider exorbitant. Walmart clearly has a solid starting position if that's where we're heading, and they’re actively testing the concept as we speak. The company’s plan to expand their network of smaller format stores in the U.S. will help move them another step ahead of the competition.”

I'd argue that this is still largely accurate. Another solid year for the Neighborhood Markets concept, with comp store sales growing more than 5%, supports this conclusion.

“Walmart 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 it can do many things with its retail footprint that Amazon cannot. This fight will continue for many years, and it isn’t winner takes all; with that said, Walmart holds an enviable hand.”

I talked about this a minute ago, but let me address these sentences directly. As time passes, I’m less convinced the retail footprint is a competitive advantage for most e-commerce transactions. In fact, I think the focus on “omnichannel” and trying to blend online and brick-and-mortar took management’s eye off the ball. Walmart’s “enviable hand”, while still strong relative to its traditional retail peers, looks less impressive when compared to the 800-pound gorilla in e-commerce. Amazon’s online offering remains miles ahead of competitors like Walmart.

“For the trailing year [fiscal 2015], management expects earnings of ~$5.10 per share; after making some adjustments (again, see my prior article), I estimate owner’s earnings is closer to $5.80 per share.”

Fast forward two years: In fiscal 2017, Walmart reported adjusted EPS of $4.32 per share (with guidance suggesting a comparable level of earnings in fiscal 2018). The reset on margins that I discussed earlier will ultimately results in zero cumulative EPS growth from fiscal 2015 to fiscal 2019 or so. The trajectory from that point forward is difficult to gauge. The investments in people (effectively the in-store experience) and e-commerce has put near-term pressure on margins. Even if the return on those investments proves attractive, it has had a material impact on earnings that likely isn’t finished. The problem for the investor is that the “long-term” doesn’t go by as quickly in real time as it does in your model.

To reiterate what I said above, I like this valuation compared with other alternatives; 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).”

For this to be accurate, sales will need to reaccelerate (in management’s defense, currency has had a material negative impact on reported revenues). More importantly, the investments discussed above will need to be digested – meaning the margin profile that Walmart has shown for many, many years is still valid. If that’s the case, there’s meaningful EPS growth compressed into the current financials that will be eventually be unloaded. At this point, that’s a big if.

Conclusion

Over the past few quarters, Warren Buffett (Trades, Portfolio) sold more than 95% of Berkshire Hathaway’s (BRK.A, BRK.B) investment in Walmart stock. Its ownership stake, which stood at 63.5 million shares at the end of 2015, is now below 1 million shares. When the Oracle of Omaha is dumping a position previously worth billions of dollars, it’s probably smart to pay attention.

Many value investors have sworn off investing in retailers. Based on my personal experience, most notably with Staples (SPLS), JCPenney (JCP), Whole Foods (WFM) and now Walmart, I should probably consider following their example. I’ve had limited success in retail.

After reconsidering my thesis, I decided to sell most of my position in late 2016. While I still own a few shares, I do not believe the risk/reward balance is as attractive as I previously thought; in my mind, both of those variables have moved in the wrong direction over the past 12 to 18 months.

I’m not making a bet on where the stock will trade next month or next year. I’m making a statement about where I believe the opportunities and risks lie for Walmart five-plus years down the road.

I continue to believe that CEO Doug McMillon is doing a good job. Unfortunately for him, he has been dealt a tough hand – and he’s facing a damn good card player in Jeff Bezos.

As always, I look forward to your thoughts.

Disclosure: Long Walmart and Berkshire Hathaway (NYSE:BRK.B).

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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