Description

BUSINESS SUMMARY  

Wal-Mart Stores, Inc. operates retail stores in various formats worldwide. It operates in two segments, Wal-Mart Stores and SAM’S CLUB. The Wal-Mart Stores segment comprises supercenters, discount stores, and neighborhood markets, as well as an online retail format, Walmart.com. It offers apparel for women, girls, men, boys, and infants; domestics, fabrics, and notions; stationery and books; shoes; housewares; hardware; electronics; home furnishings; small appliances; automotive accessories; horticulture and accessories; sporting goods; toys; pet food and accessories; cameras and supplies; health and beauty aids; pharmaceuticals; jewelry; and optical, as well as photo processing services. The neighborhood markets include dry grocery, meat, produce, deli, bakery, dairy, frozen foods, pharmaceuticals, photo processing, health and beauty aids, household chemicals, paper goods, general merchandise, and pet supplies departments. The SAM’S CLUB segment comprises the warehouse membership clubs in the United States and samsclub.com. It offers hardgoods, softgoods, software, electronics, jewelry, sporting goods, toys, tires, stationery and books, grocery items, and selected private labels. As of January 31, 2006, the company operated 1,209 discount stores, 1,980 supercenters, 567 SAM’S clubs, and 100 neighborhood markets in the United States and internationally. It operated 11 units in Argentina, 295 in Brazil, 278 in Canada, 88 in Germany, 398 in Japan, 774 in Mexico, 54 in Puerto Rico, 16 in South Korea, and 315 in the United Kingdom, as well as 56 stores through joint ventures in China, as of the above date. Wal-Mart Stores was founded in 1945 and is based in Bentonville, Arkansas.

INVESTMENT THESIS  

Wal-Mart is the world’s dominant retailer but selling at a substantial discount to fair value. In 1999 Wal-Mart, then trading at $70 per share, was voted the most admired company in America. In 2007 the company’s reputation suffers due to repeated attacks from several vocal interest groups as well as a weakening consumer. However, consider that the company is trading at $48 per share or 31% less than in 1999. Meanwhile, Wal-Mart’s sales per share have increased from $37 to $83 – up 125%. Its dividend per share has increased from $0.19 to $0.64 – up 237%. Its price-to-earnings ration (P/E) is down from 55 to 16 – a decline of 70%.

STRATEGY 

Wal-Mart grew from the idea of serving lower-income people, a market most companies previously avoided. Founder Sam Walton said, “Our key strategy was simply to put good-sized discount stores into little one-horse towns which everybody else was ignoring.” Wealthy people in large cities do not need discount stores. The idea of offering lower prices as a great benefit to customers permeates Wal-Mart’s corporate culture. “We’ll lower the cost of living for everyone, not just in America, but we’ll give the world an opportunity to see what it’s like to save and do better,” Walton said in 1992.”

Wal-Mart’s latest 10-K filing states:

Wal-Mart Stores is a global retailer committed to improving the standard of living for our customers throughout the world… We price items at a low price every day so that our customers trust that our prices will not change erratically under frequent promotional activity.

Wal-Mart is the world’s largest retailer as well as the country’s largest grocer. That size gives it an advantage. For example, Wal-Mart sells more DVDs than anyone, buying about 40% of Hollywood’s DVD output. It is the largest jeweler in the United States. And it sells about 19% of all prescription drugs in the U.S., a number that will likely rise with the new $4-drug program. Bottom line: Wal-Mart’s size means that when it goes into a new category of retail, it usually kills the competition. Toys-R-Us was a category killer in toys--that is until Wal-Mart entered the market. It now sells more toys than Toys-R-Us, or any other company.

Wal-Mart’s strategy is to undercut and outsell its competition. In Sam Walton’s autobiography, Made in America, Walton wrote that he never played in a losing football game in his entire life. In his book he wrote “Later in life, I think Kmart, or whatever competition we were facing, just became Jeff City High School, the team we played for the state championship in 1935.” Sam Walton developed an expectation of winning early in life. That drive and intensity still permeates Wal-Mart’s corporate culture today.

Wal-Mart’s goal to offer merchandise at the lowest price is a competitive advantage that prevents competition from entering its niche. No one wants to compete with Wal-Mart. In a typical business transaction, the buyer wants the highest price for its goods while the buyer simultaneously demands the lowest possible price. Each side of the transactions wants what is worst for the other side. Wal-Mart has flipped that around--the best thing for Wal-Mart, its employees, and shareholders is to offer the customer the lowest price.

Berkshire Hathaway vice chairman Charlie Munger made an interesting comment about Wal-Mart at WESCO’s annual meeting in May. “Costco would be worth a lot more money if there weren’t any Wal-Mart – whereas when Wal-Mart rose, there wasn’t any other Wal-Mart.” Munger added that Wal-Mart is “the best in the world by a broad margin at their basic retailing.”

VALUATION 

Wal-Mart’s stock is both safe and cheap. Wal-Mart sets the global bar for the definition of the word “competitive” in retail. It has a competitive advantage that will stand for many decades to come. No matter what product you can create through innovation, Wal-Mart can just about always offer it at a lower price than anyone else. That is a safe business.

Wal-Mart currently trades at 11x times its trailing 12-month pretax earnings. That’s a pretax earnings yield of 9.1%. Consider a scenario where someone offered you a Wal-Mart bond with a 9.1% coupon, and you were a bond buyer seeking a safe income. Consider also that Wal-Mart is rated ‘AA’ by Standard & Poor’s and a 10-year US Treasury is currently yielding 4.9%.

That in itself should make for a solid investment, but now consider that this 9.1% coupon will grow at 12-15% per year for the next five to ten years. Since 1990, Wal-Mart’s earnings per share (as per Value Line), have grown at 15% per year. Our hypothetical 9.1% coupon pays more than 4% above a comparable US Treasury. Inflation is the bane of  bonds with fixed coupons. Wal-Mart’s 9.1% pre-tax earnings coupon will continue to outpace inflation’s corrosive effects each year by a healthy margin.

Looking at Wal-Mart’s income statement, you will see that operating and pretax margins from the last four quarters are 5.9% and 5.4%, respectively. The margins may be thin, but returns on capital are excellent. Since 1998, Wal-Mart’s returns on equity (ROE) have been about 20%, and returns on total capital between 12% and 15%. Wal-Mart has increased its debt burden from $10 billion in 1996, to more than $33 billion today. While Wal-Mart’s debt-to-equity remains roughly 55%, the debt burden has grown easier for the company...Wal-Mart’s ratio of earnings to fixed charges has increased from 4.15x in 1996 to 9.1x today.

Using a discounted cash flow model to value Wal-Mart, a conservative 10% discount rate was employed. Value Line’s estimates for future revenue growth were used and also assumed current operating margins would continue, although they are more likely to expand than not. Under these assumptions, Wal-Mart’s fair value is around $68 per share. 

Catalyst