Wal-Mart worth $90-$100/share? I believe that over the next few years, WMT’s shares could easily more than double, even assuming the low to middle range of what management is projecting for the business. With a P/E of 13.4x (FY08 consensus), 14% after-tax ROIC, 20% ROE, double-digit EPS and free cash flow/share growth, tremendous real estate holdings (95+% of US store base is owned), Wal-Mart is priced at meaningful discount relative to: 1) other retailers and “best of breed” consumer product companies, 2) its fixed income securities and 3) its free cash flow generation potential, given that working capital growth will likely be slower than earnings growth and capex will be reduced, allowing for an acceleration of share repurchases and dividends. Moreover, what is particularly attractive about the WMT situation is that you have good upside potential with minimal downside risk considering that a below-market multiple on “recession” earnings and the real estate value in WMT’s growing store base underpin the stock price at current (and higher) levels.
Operating over 800MM square feet globally, WMT has historically grown square footage by 8% per year, however after 2+ years of low single-digit comp store sales growth, in October of this year, WMT outlined a plan to slow and refocus new store expansion to maximize returns on invested capital rather than trying to maintain historical square footage growth. WMT is also trying to improve returns in its international division, where return on assets are substantially lower vs. the US by increasing its scale (i.e. through growth and acquisitions in markets where it has been successful and entry into hyper-growth international markets such as China). WMT’s total square footage growth is now expected to slow to ~6% per annum for the next several years. This new focus should improve operating performance as the company aims to maximize store volumes at existing locations before adding new nearby warehouses (which has historically led to self-cannibalization). As a result capex will decline, and free cash flow will increase for accelerated share repurchases, dividend hikes, and potential international acquisitions.
On the merchandising front, in 2006-2007 management made some errors in merchandising in the apparel and home areas by focusing on higher-end and fashion-forward merchandise to better compete with Target. This strategy turned out to be unsuccessful, as WMT lost touch with its core customers, who shopped there not for the latest fashion trends, but for basics at an everyday low price. WMT management is currently correcting those missteps by re-focusing on its strengths in basic apparel and taking more modest steps in moving its product offering up the quality/price spectrum, particularly in more effectively segmenting offerings for different markets (i.e. higher income, more urban mkts vs. rural mkts compared to the previous “one size fits all” strategy). WMT is like a large supertanker attempting to turn around—clearing out merchandise and excess inventory will take some time to flow through the store base, but early results seem encouraging.
The market seems to be disproportionately focused on WMT’s weak comp store numbers as the consumer gets pinched by high oil/gas prices, mortgage payment resets, and declining wealth effects (i.e. lower cash out refinancings) in addition to the merchandising missteps made over the past 18 months. Comp store sales in the US were up only +1.4%-1.5% for the 3Q and 9-Month period of 2007 (following up 2% in 2006 and 3% in 2005) which is still underperforming the likes of TGT and COST. However, assuming WMT improves its merchandising strategy, there is likely to be a “trade down effect” (which occurred with WMT in 2000-2001), whereby customers shifted away from department stores and began spending more at Wal-Mart; in 2000 and 2001, WMT’s comps were actually up 5%-6%, which was largely attributed to this trade down effect and WMT’s grabbing more market share from cash-strapped consumers. In fact, comments on my VIC writeup for Safeway (SWY) in July 2001 were, I believe, overly enthusiastic in alleging that Wal-Mart’s everyday low price strategy in groceries was going to lead to the demise of traditional grocers such as SWY and KR. Today, you don’t get anyone trumpeting the virtues of Wal-Mart as a low-price destination that is likely to continue taking market share if a recession were to occur.
Other than the low single digit comp number, 3Q results were actually pretty impressive as WMT delivered improved operational and expense efficiencies. EPS was up 11.3% on strong inventory management (inventories up only 2.7% vs. YTD total revenue gain of 8.6%) and good expense control (EBIT margins up slightly year over year). For FY07, management is projecting total revenue growth of~9% and EBIT growth of ~8%, not bad for a company fixing its merchandising strategy and being “exposed” to a pinched consumer.
Valuation: 1) Relative to other retailers and “best in breed” companies: WMT’s 08 P/E of 13.4x, is below that of the S&P 500 (~15.6x), below that of slower growth food retailers such as Kroger (with GDP-like sales growth), and other companies such as Mc Donald’s, P&G, GE, Target and Costco. In the chart below of comps in the retail space and “best of breed” companies, WMT enjoys the lowest P/E, the 2nd highest historical EPS growth, the second highest return on invested capital, and the third highest LT EPS growth rate (consensus estimate survey per Bloomberg). Nonetheless, WMT’s P/E is 1.1x–6.4x lower vs. these other companies. Glaring discrepancies in valuation vs. ROIC and earnings growth are particularly evident with Kroger (P/E 14.7x), P&G (18.6x), and McDonalds (18.3x). ROIC metrics vs. the retailers are even more impressive for WMT considering that it owns 95% of its US stores and about 35% of its international stores. TGT and COST also own a majority of their R/E, but sport lower ROICs (focus on urban mkts) and Kroger’s ROIC can be seen as somewhat inflated because it owns less than 30% of its stores.
P/E '08 Consensus
EPS Growth Past 5 Yrs
Consensus Long-Term EPS Growth
Run-Rate ROIC
Wal-Mart Target Costco Kroger P&G McDonald's GE*
13.4 14.5 19.8 14.7 18.6 18.3 14.8
12.3% 13.5% 10.0% -0.5% 11.0% 8.0% 7.0%
12.3% 13.5% 10.0% -0.5% 11.0% 8.0% 7.0%
14.5% 12.5% 13.0% 13.5% 10.5% 15.0%
* Low ROIC of GE due to ownership of GECC finance subsidiary
Despite all the focus on WMT being a typical “cyclical retailer”, it has exhibited tremendous stability in its results even as it has witnessed poor execution in several of its initiatives and lagging returns in the international divisions. Over the past 10 years, EBITDA margins have ranged from 6.1%-6.5% (6.5%-6.6% over past 5 years), net margins have ranged from 3.2%-3.4% (now at 3.4%), ROIC has been consistently above 14% since 1997 (range: 14%-15.6%) while ROE has been above 19% (range: 19%-22%, currently ~20%). Same store sales have been up in every single year over the past 20+ years and EPS growth over the past five years has been in the low double-digits. While WMT’s margins are admittedly lower vs. some of the consumer product companies mentioned above, sales, margins, and returns on capital have actually been more stable! This points to the theory that people should be willing to pay up for stability/consistency/low probability for downside surprises.
2) Valuation of WMT equity vs. its long-term bonds: Wal-Mart’s 30 year bonds (due 2037) trade at about 170 bps over 30 year treasuries (currently around 4.42%), which means that the all-in yield for holding Wal-Marts bonds is ~6.1%. The 170 bps as a price of “risk” for a strong Aa/AA rated credit is actually near to all time highs (last occurred during 2001 recession), reflecting low treasury yields (which lowers the all-in yield) and the fixed income market’s concern of a potential recession’s impact on retailers. Wal-Mart’s stock, which at a 13.4 P/E, commands an earnings yield (inverse of P/E) of 7.7% vs. the 6.1% yield on 30 year-debt. So looking at the equity as a subordinated bond, you are paid 160 bps extra (7.7% minus 6.1%) vs. holding the debt. This senior/subordinated relationship is on par with many high-yield fixed income securities that are rated single-B and seems too wide given WMT’s rock-solid credit profile. What’s even more striking is that unlike the 30 year WMT bond, the equity offers inflation protection, a growing “coupon” in terms of low-double digit EPS growth, the accretion offered by share repurchases, a 2% current dividend yield and capex being invested at a return on incremental invested capital of over 14%! To me, a more appropriate relationship (and one that you see with most investment grade companies over time) would be that the earnings yield should be lower vs. the fixed income yield, as the earnings are growing / protect against inflation. If WMT’s earnings yield were in line with its fixed income yield of 6.1%, this would imply a P/E of 16x ($55/share on FY08 EPS), if the earnings yield were 5%, this would imply a P/E of 20x ($69/shsare).
3) DCF Valuation: While $55-$70 a share seems a long way from $90 -$100, this is where the DCF/Projections come in, and specifically the free cash flow per share metrics, which due to expected working capital efficiencies (i.e. working capital not growing as fast as sales) will likely increase at a greater rate vs. EPS over the next 5 years.
In October of this year, management outlined its expectations for the next 3 1/2 years in terms of sales growth, EBIT growth, Capex, PP&E, and working capital. The following are management assumptions:
Sales growth: ~9% for 2007, 5%-8% through 2009. Sq. footage growth of 5%-6% per annum.
EBIT growth > Sales growth (or up 6%-8%). Capex: $13.5BN - $15.2BN per annum (vs. $15-$16BN over the past 2 years) Inventory growth < Less than 1/2 of sales growth Payables growth > Inventory growth ROI (pre-tax and adjusting for operating leases) of ~ 19%-20%.
Management’s projections with regard to revenue growth seem particularly conservative given that sales growth (5%-8%) is only modestly higher vs. square footage growth (5%-6%) implying there will be 0%-2% comp store sales growth in spite of the company’s re-merchandising strategies and focus on driving better volumes on a per-store basis.
I have taken the mid-range of management’s projections with regard to sales growth projections for the next 3+ years, extrapolated the low end to 2012 and did a DCF analysis until 2012 with a year 6 (2013) terminal value assumption discounted to the present. I also assumed modest increases in dividend per share (from $0.92/share in FY 08 to $1.25/share by FY2012 and share repurchases of over $57MM (assuming average purchase price of $70/share, measuring $50-$60/share in first 2 years, and going up to $90/share by year 5). Share repurchases are assumed to be conducted at an amount that will maintain WMT’s current debt/EBITDA of ~1.5x.
Because inventories are projected to grow at about 50% of the revenue growth rate, working capital becomes a source of cash and free cash flow per share-- defined as operating cash flow minus depreciation (or a proxy of maintenance capex, which is actually a little higher vs. WMT’s actual maintenance capex)--is projected to grow faster vs. EPS.
Currently, at a 13.4x P/E, WMT is trading at roughly the same multiple on a FCF/share basis, defined as operating cash flow less depreciation (maintenance capex proxy).
Using the DCF model, these are the results: 5 Year EBIT growth of ~8% per annum 5 Year EPS growth of ~10.3% per annum 5 Year Free Cash Flow Per Share growth of ~12.8% (Operating cash flow – Maint. Capex) FY2012 EPS: $5.60 FY2012 FCF/share (operating cash flow less maint. capex): $5.93 FY2013 terminal value FCF/share: $6.29 Multiple of FY2013 terminal value of FCF/share: 15x, which is in line with the long-term average for the S&P 500 and lower vs. WMT’s comps in retailing and “best of breed” consumer products companies. Discount Rate: 10%
Results are modestly above consensus estimates 3-5 years out primarily due to my assumptions about share repurchases (that they will continue and will be funded by debt to keep 1.5x debt/EBITDA level). Actually analyst projections for the balance sheet from year 3 onwards are pretty unrealistic.
Resultant Intrinsic Value: $84/share
Now for the sensitivities:
A) Discount rate: I originally assumed 10%, which is actually conservative considering WMT’s 30-year bond yield is at 6.1% and the earnings yield is currently 7.7%. Let’s assume that the “price of riskiness” of holding WMT equity should be 200 bps more than WMT’s 30 year bond yield (which I argued in #2 above is too conservative), for a revised equity discount rate of 8.1%
At an 8.1% discount rate, the resultant Intrinsic Value/Share: $90/share
B) Terminal Value: I applied a simple multiple to 2013 free cash flow per share. The academic way of looking at the terminal value would be to take the free cash flow per share and divide it by the denominator of the required rate of return minus the constant growth rate (the k-g) aspect. Assuming the required rate of return is 10% in perpetuity and WMT’s long term growth is 5% (slightly higher vs. GDP growth, which is not unreasonable considering WMT’s international exposure, and remember consensus LT EPS growth is 11.5+%), you get a terminal value “multiple” (i.e. 1/k-g ) of 20 (which incidentally bolsters the argument that WMT’s current P/E is too low).
Resultant Intrinsic value based on terminal multiple of 20x and 10% discount rate = $103/share
Resultant Intrinsic value of the above, but an 8.1% discount rate = $111/share
C) Leverage: I assumed that share repurchases would be conducted at level whereby Wal-Mart maintains the same debt/EBITDA ratio of 1.5x over the projection period (similar to what it is today). If WMT were to increase leverage by 0.5x to 2.0x debt/EBITDA starting in 2008, share repurchases would total $89BN-- or 48% of the current market cap (vs. $57BN in original projection) and again assuming an average purchase price of $70/share, would be further accretive to FCF per share, which would increase to $6.80 from $5.93 (original projection) and EPS would increase to $6.40 from $5.60. Because of WMT’s reduced capex, and working capital as a source of cash (with inventory growth < sales growth, and payables growth > inventory growth), there is tremendous capacity to buy back shares without significantly deteriorating WMT’s strong balance sheet:
Resultant Intrinsic value at 10% discount rate, 15x terminal FCF multiple = $96 share.
Resultant Intrinsic value at 8.1% discount rate, 20x terminal FCF multiple = $126/share
In sum, a $90-$100 per share intrinsic valuation for WMT is not unreasonable and with the dividend increasing at a similar rate to earnings growth and totaling a cumulative $5.40/share over the next 5 years, the total return potential vs. the current price is ~106%- 130%
Downside Analysis:
As mentioned above, I believe WMT is a relatively safe-haven because of the company’s below average earnings risk/volatility and very consistent margins and returns on capital (as can be seen from historical results). If we were to enter into a recession in 2008, and WMT would still be having problems with its merchandising/inventory, comps would likely be 0% to –1% range. Comps falling below –1% would be unlikely given that 30% of WMT’s sales are related to grocery/consumables (more stable demand characteristics, even before considering the ‘trade down effect’). Comps below this would imply that apparel would have to be down roughly 10% on per store basis. A recession case EPS number would be about $3.25 per share for 2008 (consensus = $3.47), which at a 13x multiple would be at $42.25 (8% downside).
WMT’s real estate value should also underpin the stock in the coming years. Because WMT owning 95% of its US stores and 35% of international stores, a reasonable proxy for WMT’s real estate value would be to look at the undepreciated book value of its PP&E. Gross PP&E currently measures about $118BN or $29/share. WMT will be increasing its gross PP&E by $13-$15+BN per year over the next 5 years. By 2012, WMT will have about $191BN in PP&E or $59/share (assuming all free cash flow not used for dividends or capex is directed to share repurchases --which reduces shares outstanding substantially as discussed previously. $59/share in R/E value plus cumulative dividends of $5+ over the next 5 years provides some downside protection = $65 minus debt/share of $20 = $45/share.
Upside Potential:
Management’s projections pretty much assume that returns on invested and incremental capital don’t diverge too much from today at around 14%-15% after tax. What’s interesting to note about this is WMT’s international division earns substantially lower returns on assets vs. its US division. The company is focused on improving international returns by exiting unprofitable markets (e.g. most recently Germany and South Korea), continuing to build scale to leverage its fixed costs in already successful markets (UK, Mexico, Canada, Japan) and penetrating markets with high potential growth (such as the Trust-Mart acquisition giving WMT a foothold in China—where WMT is performing very well) . Assuming the company is only modestly successful in closing tthis gap, it could imply even more upside for WMT’s shares.
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