WAL-MART STORES INC WMT
February 22, 2011 - 12:48am EST by
alex981
2011 2012
Price: 55.38 EPS $4.07 $4.54
Shares Out. (in M): 3,571 P/E 13.4x 12.2x
Market Cap (in $M): 198,000 P/FCF 12.5x 11.0x
Net Debt (in $M): 41,000 EBIT 25,600 27,250
TEV ($): 239,000 TEV/EBIT 9.3x 8.7x

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Description

Wal-Mart has been written up three times in the last four years, so it's hard to come up with much new to say beyond simply updating the numbers and pointing you to the last three write-ups as evidence that the stock is really cheap.   I did my best to make it worth reading by trying to add some new analysis and insight, but since most people are familiar with the company, I've cut out a lot of the stuff that might normally be in a writeup, such as a discussion of management, competitors, etc.  If anyone has questions about those things, I'll address them in the comments.  

Thesis

Walmart, as you may be aware, is a major global retailer.  It has major sustainable cost advantages versus its competitors, particularly in the United States.  It has a AA balance sheet.  It is currently trading at 12x CY2011 earnings of $4.54, and 11x CY2011 maintenance FCF of $4.95.  I reckon this is cheap.  At, say, a 6% MFCF yield (which, given the current environment for bonds and bond-like assets like real estate and utilities, is not unreasonable), it would be trading at over $80.  Not in a year, or two years, but today.  Against a current stock price of $55, that's not bad.

To be fair, compared to other equities, it's doesn't look quite as cheap.  Maybe you say at 14x MFCF it would trade at only $70.  Fine, still cheap.  Or, look at it this way: it's yielding 9%, and over time, MFCF should be able to keep pace with inflation without adding any new capital (if I have calculated MFCF correctly, and their competitive position holds).  If inflation runs at 2%, you get total return of 11% annually in perpetuity.  If they can build new stores at a good return, or cut costs faster than their competitors, it's icing on the cake.

Maintenance FCF

Before diving into a discussion about the business, I should probably defend the reasoning behind using maintenance FCF, since it is significantly higher than EPS.  Walmart owns a lot of real estate; most of their stores are in buildings they own.  It is convention, when looking at real estate, to add back depreciation when calculating net operating income.  This makes perfect sense; a properly maintained building in a desirable location will not wear out or become obsolete.  If an investor believes the building will not hold its ability to generate income for one reason or another, it will be factored into the cap rate.     

I believe that what is good practice when analyzing a REIT which has all of its value tied up in real estate is good practice when analyzing a publicly traded company that has much of its value tied up in real estate.  The cash flow in excess of net income is perfectly real and mostly sustainable.  They will need to relocate or close some stores at some point down the road as population shifts and locations become obsolete, but right now most of the stores are relatively new, and the number of annual store closings is almost negligible, and there may be some value left in the building once the store closes anyway.


Total


Per Share*




2009 Buildings and improvements, gross

$77,452













Annual depreciation (40 year life)**

$1,936


$0.55




Maintenance capex in excess of depreciation***

($500)


  ($0.14)




Difference between EPS and MFCF

$1,436


$0.41











CY 2011 Net Income

$15,900


$4.54




CY 2011 Maintenance FCF

$17,336


$4.95


















*Proportion of which is tax shield (34% rate)

$658


$0.19











**Plucked out of thin air...or, about 10% of annual non-building depreciation, due to the effects of inflation.








***Based on 3,500 average shares outstanding during 2011, fully diluted.




 

As you can see, building depreciation has a significant impact on reported net income.  This effect will dissipate with time, but most of Walmart's buildings are relatively new (at least in real estate terms).  Retail square footage is almost 1 billion square feet today, but only this figure was only 500 million a decade ago and 125 million two decades ago, and virtually all of the additions are newly constructed buildings.

To get to an accurate estimate of MFCF, we have to also deduct maintenance capex related to the buildings (probably minimal enough to be ignored right now) as well as maintenance capex in excess of depreciation for the non-building capital equipment used in the business.  Walmart has a whole host of capital equipment that depreciates over a course of several years and has to be replaced, from improvements to the stores to trucks to computer systems.  Inflation guarantees that the cost to replace these assets will exceed the depreciation allowance on the income statement based on historical cost.  Depreciation related to these assets comes to a bit over $5 billion a year, and I assume this is inadequate by 10% - this equipment apparently lasts about seven years on average, so let's say the average age is about four years and inflation is 2.5% per year.  (Yes, I've made a ton of assumptions, but this is probably in the ballpark).

I would add that the company also breaks out capex by category (new stores, distribution, IS, remodels, etc), and you can get a similar result by classifying each category of capex as maintenance, growth, or a mixture of both.  I just felt that this was more intuitive and less arbitrary (what is the normalized level of remodels? How much of distribution capex is really growth?).

It is also worth noting that while some of the difference between net income and MFCF comes from depreciation being an accounting expense for which there is no corresponding cash expense, some of MFCF comes from the tax shield generated from building depreciation.  I footnote this portion since it is certainly of lower "quality"; it is a cash flow that will stay constant over time and then go away when the building is fully written off, and it lowers the cost basis, triggering tax if Walmart wishes to sell the building down the road. 

Business Overview

Walmart U.S.

Walmart U.S. generated about $20 billion in operating income last year, on $260 billion in sales in 3,800 stores.  Sam's Club did an addition $1.7 billion in operating income; combined, they account for over 80% of WMT profits.  Half of sales are classified under "grocery" (both food and household products), with the balance consisting of more discretionary categories such as home, electronics, and clothing.  They operate "big box" stores that cater to low/middle income households, mostly in the rural and suburban areas of the country.

A Walmart executive once stated at an investor meeting, "The misconception is that we're in the retail business.  We're in the distribution business."  (For the record, while most shop there for the low prices, I think the Walmart retail shopping experience is underrated).    

Distribution is where Walmart distinguishes itself.  Walmart was a pioneer in buying direct from manufacturers and handling most of the distribution themselves.  They built distribution centers where trucks dropped off goods from manufacturers that would be quickly sorted and put on to different trucks that would take them to individual stores.  Today, most major retailers have a network of distribution centers which handles a significant portion of their merchandise (though maybe not as much as Walmart's 80%), but Walmart was the first and the most advanced, and as a result they were able to spread across the country before others got off the mark. 

Walmart expanded by first building a distribution center, and then building as many stores within a close radius as the market and the distribution center could handle.  The fact that they expanded this way allows them to benefit from "economies of density"; the average store is much closer to a distribution center than it is for their competitors, which means that merchandise doesn't have to be trucked as far, among other benefits.  (If you want to read more about the subject, and haven't yet gotten to your latest issue of Econometrica, see this).  I believe this provides them with a sustainable cost advantage over potential and existing competitors.  The fact that they have four times the sales of any domestic competitor, giving them significant leverage over their suppliers, doesn't hurt either.

Walmart International

I estimate Walmart International will contribute $5 billion to operating income this year (after backing out minority interest), while the US operations will contribute $22 billion, so this is a significant but not yet crucial piece of the puzzle. Walmart has a number of operations around the world, but its chief contributors to the bottom line are its operations in Canada, the UK, and Mexico. 

Walmart owns a 68.5% stake in Walmex, a publicly traded retailer that does business in Mexico and Central America, and this contributes about 30% of international operating income (again, after backing out minority interest).  Canada and the UK probably come to about 20%-30% each.  They have a significant business in South America that probably accounts for most of the remainder.  In addition, they have a big business in Japan they are in the process of turning around; while it doesn't contribute anything today, it seems to be turning around and could be a positive factor in the future.  They also recently acquired a business in South Africa, and have JVs in China and India.

Walmex is generally considered to be the crown jewel.  WMT as a whole currently trades at about 9x EV / CY 2010 EBIT; on $5 billion of operating income, Walmart International would implicitly be worth $45 billion.  However, Walmart's stake in Walmex is worth over $35 billion at Walmex's current trading price.  The market's valuation of Walmex (27x 2011 earnings) may be a bit frothy, but not necessarily totally irrational; they have a strong position in their home market, and operating income has doubled in the last five years, even as the company has paid a healthy dividend and repurchased stock, and it should be able to grow at a double digit rate over the next few years.

Walmart's businesses in Canada and the UK are more mature, and will not be major growth drivers.  In the UK, they are in a more difficult competitive position as the number two player behind Tesco, and the business has been weak as of late.  In Canada, Walmart has 317 discount stores and supercenters, and is still adding units and converting discount stores into supercenters.

Why is it cheap?

Before addressing company-specific factors, I think it's worth observing that megacap equities garner lower valuations today than they have in the past.  It has been argued that this stems from the declining popularity of stocks among retail investors and pension funds, which tend to allocate a disproportionate amount of capital to megacap stocks.  Evidence from mutual fund flows and pension allocations seem to support this hypothesis.  In general, I think there is a lot of selling here for non-economic reasons.

WMT has been downgraded by three analysts in the last month, so clearly it's not just being part of an unpopular asset class that has hurt the stock.  One thing that has clearly weighed on the stock is weak comps.


Walmart U.S. Only

CY 2008 Q1 09 Q2 09 Q3 09 Q4 09 CY 2009 Q1 10 Q2 10 Q3 10
SSS 3.2% 3.6% -1.5% -0.5% -2.0% -0.2% -1.4% -1.8% -1.3%
Sales 6.8% 3.8% 0.3% 1.2% -0.5% 1.1% 1.1% 0.0% -0.1%
Op. Income 7.1% 3.3% 5.0% 6.9% 6.8% 5.6% 5.6% -0.2% 1.9%

Though comps have been hurt by the weak economy, low inflation, and rising gas prices, another major factor has been poor execution.  Walmart underwent an intiative which included eliminating some SKUs and moved toward more promotional pricing (versus the everyday low price strategy that had been their hallmark in the past).  Both of these initiatives ended going too far and hurting traffic and sales.  Once they figured out they went too far, they backtracked somewhat.

I would also note that they managed to find positive operating leverage despite negative comps and traffic; this is reversal from the trend over the past several years, where comps had been positive and margins were flat to declining.  This in part because they are lapping a period where they had heavier investment in systems, but I think it is also clear they are not reinvesting cost savings into lower prices as aggressively as they have in the past.  Walmart competes with dollar stores and Aldi on the low end, and retailers such as Target on the higher end.  When invest money into cleaning up the stores and removing some of the clutter to better compete for the Target customer, they might have lost some of their lower-end customers that only care about price and assortment.  Though management would never say so publicly, Walmart cannot be all things to all people, and at some point it doesn't make sense to lower prices to get every last customer.  

Estimated 2011 Capital Allocation




Estimated CY 2011 maintenance free cash flow $17,336





New store / expansions capex - U.S. (budgeted) $4,200

New store capex - Int'l (budgeted) $2,750

Total capex for new stores and expansions $6,950
40%




Remaing for dividends, repurchases, acquisitions $10,386
60%

Another worry for investors is capital allocation.  Right now, about 40% of FCF after maintenance capex is slated to go toward building additional square footage.  Building new stores is not as much of a slam-dunk proposition as it once was.  Domestically, a lot of the capex is to fund their push into urban markets, where they have not really been before, so returns are more uncertain than usual.  However, the fact that 60% of cash flow generated is returned to shareholders (unless they do acquisitions, which might cut a couple billion at most out of the total), gives some confidence that they won't squander too much of the money they make. 

Catalyst

It's been trading at the same price for about 11 years now - I'd say it's about due.
 
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