Description

Walmart's valuation reminds me of Yogi Berra's quote: "Nobody goes there anymore.  It's too crowded."  I will refer readers to mark744's write-up from November 2007 for some background on WMT and a lively discussion about DCF methodology.  I agree with mark744's conclusion of a $80-100 stock price, but given that the stock price is not that different from two years ago, I will focus on some alternative ways of looking at WMT's valuation and an emphasis on what's changed.

Obviously, WMT needs no introduction - or does it?  Everyone has an opinion about WMT in a way they have an opinion about General Motors or Microsoft or any other huge company that comes in contact with people nearly everyday.  I believe that the general impression in the financial community and the mainstream media is that WMT is a behemoth company that cannot grow because of its size, buys low-quality goods from sweatshops in China that dump their waste into nearby rivers, and exploits its workers while the company is run by a bunch of Arkansas country bumpkins.  While some of this may have been true about 5-10 years ago, it is not any more.  So what IS Walmart?

Walmart is ...

1) ... indeed the world's largest retailer, with over 8,000 discount stores and supercenters.  With so much purchasing volume, WMT can get better prices to pass onto its customers.  While still largely concentrated in the U.S. (76% of revenues and 80% EBIT), it is growing faster abroad through both acquisitions and organic growth.

2) ... the world's best large retailer, based on a long-term evaluation of Gross Margin Return on Inventory (GMROI).  GMROI is a well-accepted measure of productivity for retailers.  Because it isolates the core element of retail (getting the right product on the right shelf at the right time), GMROI can be used to compare retailers and is commonly used within retail organizations to optimize store space between departments and products.

Of 46 publicly-traded companies (on the US and international exchanges) that compete with WMT, only 13 have adjusted ROIs (capitalizing rental expense) of 15% in their last fiscal year.  Of those, only WMT has increased GMROI every year since 1997, including the last fiscal year, which did most retailers in.  Here is some of the GMROI data among the best retailers (note that retailers are best compared to themselves as GMROI is dictated by the merchandise mix.):

Given that WMT has continued to take inventory out of their stores (in Q2, inventory was down 4.3% overall despite a revenue decrease of 1.4%.  US/Sam's inventories were down 5-6%), it's likely that they will continue to improve their GMROI performance.

3) ... the world's largest retail property manager.  As of the end of 2008, WMT owned 642m square feet of retail space in the US and abroad (87%/13% split), which is 70% of its total space.  This is 2.5x the space of Simon Property Group and 3.4x the space of General Growth Properties, which are the two largest retail REITs in the world, and 3.4x Target's owned square footage.

As you can see in the table below, WMT has significantly higher profitability per square foot, lower debt, and a valuation that is just on par with Simon.

Of course, WMT's properties are huge single-purpose facilities without much use other than being a supercenter (although I have seen a shuttered big box retailer unit converted into a call center), but the same can be said for Simon.  What else are a large suburban malls going to be?

4) ... the lowest priced retailer in the current retail environment - and price really matters now.  Study after study comes out showing that WMT has the lowest price basket against all other retailers.  Around the world, WMT is pursuing its Every Day Low Price (EDLP) strategy, and as a result is taking share.  I'll quote my own 65-year old father here, who doesn't really like WMT because of a liberal bias (more on that later) and actually works for a competing grocery store.  He says, "I don't really want to shop there, but I can't afford not to."  So far this year, 10-15% of WMT traffic growth has come from new households, who spend 40% more than existing WMT customers.

The bear case on WMT is that those new customers will leave WMT as soon as they can because of an unpleasant shopping experience.  To counter this, WMT is renovating all of its existing stores over the next 5 years (they will be 32% through by the end of this year) to a new format called "Project Impact", which reduces aisle clutter and inventory, improves sightlines, and provides for a better shopping experience.  I have been to several Project Impact stores, as well as unrenovated stores, and the differences are dramatic.  In the remodels, WMT is seeing better customer experience scores, higher sales, unchanged gross margins, and lower inventory levels (relative to a control group of stores).

5) ... run by sophisticated folks based all over the world - not country bumpkins from Bentonville.

The Current CEO, Mike Duke, was the CEO of Walmart International and doubled that business through organic growth and acquisitions.

The CEO of Walmart US (also Vice Chairman) ran Walmart Mexico and doubled that business in his five years there.  He's a Mexican and has an engineering degree from Texas A&M.

The CEO of Walmart Latin America is a Spaniard who speaks six languages.  He grew Walmart Brazil from 10 stores to over 300.  He runs that operation out of Miami.

The CEO of Walmart.com has two engineering degrees from Stanford and an MBA from Wharton. 

The SVP of Financial Services (prepaid cards, money transfers) is a Harvard Business School graduate who works out of Chicago.

The VP of International Financial Services is a Harvard Business School graduate (Baker Scholar no less) and McKinsey alum who also worked as a banker in Argentina.

This is just a flavor of who they are recruiting in the organization.  In general, they have a sophisticated team that understands why people shop at Walmart, and they're trying to remove the barriers to shop.

Incidentally, Walmart store managers make between $100-150K before bonus.  Because of the economic environment and their improvement in reputational issues, WMT is seeing resumes that they would never have seen before.

6) ... , in the investment world, a victim of a Northeast bias and legacy reputational issues.

I continue to believe that one of the biggest issues is that business reporters and the investor base are simply not WMT customers and even look down upon WMT customers.  And since there are few WMT stores around NYC, Chicago, and San Francisco, investors don't have much of an opportunity to change their minds despite the progress WMT is making more broadly with its reputation.  After several years of concerted efforts to improve its reputation on issues ranging from environmental responsibility, human resource management, diversity, and health care, WMT has made more progress with unions than with people whose household income is greater than $80K.  (WMT tracks "favorability" ratings with different groups, and the latest survey showed that 64% of union members had a favorable opinion of WMT, while only 61% of $80+ household income members did.)

WMT continues to make progress on this front, and will change the perception little by little.  Now if I could only get them to stock more organics at the nearby Neighborhood Market, maybe even my Northeast-bred wife would shop there...

7) ... attractively valued in a number of different ways.

a) No growth capex FCF yield:  WMT's cash flow generating abilities are masked by continued capex spending ($14b expected in FY10).  However, if WMT gave up on its growth capex (63%) and decided to focus solely on existing stores, it would generate $15b of cash (7.5% levered FCF yield).

b) DCF analysis valuing the current store base separately from the new stores:  fairly modest assumptions (3% top-line growth; modest margin expansion; 2% terminal value growth) generates a stock price of around $70.  New stores to be built over the next few years will add another $10-15/share.

c) Sum-of-the-parts:  There are three parts of a sum-of-the-parts analysis: Walmart Mexico (Walmex)/Latin America, Japan turnaround, Mature Markets.

Walmex is publicly traded, and WMT owns 67% of that $32b market cap entity ($21b value to WMT).  So Walmex represents 10% of WMT's market cap, and it's trading at more than twice the valuation of WMT (19.5x EBIT).  Walmex is one of the most successful parts of WMT: multiformat, extremely high retailing ROA (12%), and excellent margins (8% EBIT vs. 5.6% total).  It is really a model for the rest of Latin America (mostly Brazil, which has grown its store base by 8% in the first 8 months of the fiscal year).  If you apply that valuation to the rest of Latin America (I used only a 5% EBIT margin assumption), the equity value is $15b.

WMT's Japanese subsidiary Seiyu is undergoing a turnaround.  WMT first entered Seiyu by buying a minority stake in FY06 but was unable to effectuate operational changes and implement EDLP until the second half of 2008, when they acquired the rest of the company.  Since then, WMT has been lowering SG&A expenses (down 350 bps since FY08) and is now break-even. 

Seiyu is now the only Japanese retailer with positive comp store sales results. Seiyu should extend its lead as WMT makes an impact on the Japanese retail industry, which is dominated by "trading houses" or distributors.  For example, WMT can save Japanese consumers 50% on a new Clorox "Greenworks" product by importing it directly from Clorox vs. going through the typical Japanese retail supply chain.  Keep in mind that the new CEO of Asia (three weeks on the job) has a background in Asian operations at Coca-Cola (consumer branded products) and DHL (international logistics) - not retail.  According to the CEO of Walmart Japan, there are several more years of 100+ bps reductions in SG&A and that "4% EBITDA is not at all out of the question for us in a reasonable period of time."

For the valuation of WMT Japan, I apply 3% EBIT margin and EV/EBIT multiple of 7x, and the resulting equity value is $1.8b.

Mature Markets (U.S./Sam's, Canada, UK):

Adding up the equity value of Walmex ($21b), Other Latin America ($15b), and Japan ($2b) implies a market cap of $165b for the Mature Markets.  Adjusting for the corporate debt ($45b) and cash gives us an Enterprise Value of $203b.

Adding up the LTM EBIT of the Mature Markets, plus fully burdening this group with all the Unallocated Corporate expense results in LTM EBIT of $21b.

So the Mature Markets are effectively trading at only 9.6x LTM EBIT, an attractive valuation for a best-in-class retailer with sustainable competitive advantages - and you get WMT's emerging efforts in China (where they've grown store count by 17% so far this year) and India for free.

8) ... a growing company with multiple ways to improve shareholder value meaningfully

Unsurprising for a company this size, there are many initiatives going on at the same time.  I will highlight two key ones.

A)       A new global sourcing initiative alone has the potential to increase EBIT by 15-25% over the next five years.  This is focused on two main areas:

(i) Ensure that as many products as possible come to WMT directly from suppliers, as opposed to distributors (or mostly direct importers). 

(ii) WMT controls $100b of its own cost of sales (private label products, private brands, raw materials for its own products).  They have created teams to create specs, consolidate purchasing power across the organization, and monitor supplier quality.  Early examples of the impact: saving 10% on apple purchases for Walmart US, Sam's Clubs, and Walmex.  They are embedding themselves into their suppliers' processes such that they have consolidated purchasing power for steps within the cardboard manufacturing process.

a. Management believes they can save 5-15% of this annual $100b over the next five years.  Even if they give 50% of that to their customers in price savings (which should drive higher traffic), it would result in 15-25% higher EBIT.

More importantly, they are adding significant resources to these initiatives.  Eduardo Castro-Wright, CEO of Walmart US and Vice-Chairman, said to me at the recent Investor Day, "I'm spending all of my time on this."  They have added more than 100 people to Global Sourcing in several locations and it's touching many, many areas ranging from clothing to hardlines to food.

Even more importantly, there is evidence that this is all working.  WMT has nearly completed its relaunch of its Great Value private label program, which was not only done for the typical private label reasons, to improve margins and keep branded vendors honest.  The relaunch was also done in order to build the infrastructure for developing product specifications, quality control procedures at their vendors, and consistent packaging standards in products from frozen foods to mustard to bread.  This infrastructure build is more important to WMT than your typical expectation of private label programs.  They are now taking their "learnings" (in WMT's vernacular) to other areas including apparel, homegoods, etc.

B) After 10 years of a stagnant stock price, there seems to be a real push to increase shareholder value.  In June, WMT announced a $15b stock buyback (~8% of the company at the time), and got to work immediately, buying $1.3b in June and July alone.  I estimate that even after paying $4b in dividends (2% yield), WMT could buy back stock and drive EPS above $4.50 by FY12.

If buybacks don't work, WMT could IPO their other Latin American subsidiaries like they did in Mexico.  It's hard to know how seriously this has been considered, but based on a comment by the International CEO, it sounds like they have actually studied the cost/benefit in some detail.

Risks:

• Shoppers who have driven WMT's market share up will leave them once the economy improves. However, I believe that profligate and wasteful consumer spending will be challenged for a long time as people learn how to live within their means.
• Overall growth will rely on international expansion, and WMT has an inconsistent record at that (very good in Mexico and Latin America; very poor in Germany and Korea, where they exited). However, with the exception of China and India, which are both very new start-up operations, WMT has extensive experience and success in all of their markets. That they have shown quick progress in Japan is a great sign.
• WMT is the defendant in the largest gender discrimination class-action lawsuit. The case goes back to 2001, but it covers all women employed by WMT US from 1998. No one talks about this much, but it's still out there.
• Specialty competitors more nimble than WMT figure out how to compete around them. Petsmart is a real challenger in pet supplies; Staples is tough in office supplies; Costco is a tough competitor to Sam's. But Walmart, especially over the past 3-4 years, has shown that it can fight back and innovate in its own way.

Catalyst

Accelerating international growth

Buybacks drive up EPS

Global sourcing initiative bears fruit

Continued sluggish economic environment