Wal-Mart: Not So Safe Haven in a Challenging Economy

Wal-Mart (WMT) (51.56, $202 billion market value) had a spectacular year in 2008, rising 18% in price while the overall market eroded 37%. Going into a year with a relatively low valuation at the time and benefitting from the precipitous decline in gasoline prices and stimulus checks that boosted the wallets of their customers as well as their low-price position that attracted consumers looking to trade down, it isn't that surprising that the stock was in strong demand. On January 8th, though, the company signalled that all is not well in Bentonville, sharing a stark reminder of how challenging the economy is for even the best positioned. The stock reacted accordingly and fell sharply, but I expect this to be the first of many resets that will hurt the stock further.

Before I explain myself, though, do me a favor and take this pop quiz (no cheating!):

How much net debt does WMT have?

• a) None (they have more cash than debt)
• b) Very Little (less than $10 billion)
• c) Better than most companies ($17 billion or 20% Debt to Capital)
• d) Typical for S&P 500 Companies ($25 billion or 28% Debt to Capital)
• e) More than average ($41 billion or 39% Debt to Capital)

Do you have your answer? I don't spend a lot of time analyzing very large companies typically, and I would have guessed b or c. The correct answer, though, is actually e (more than average).

As anyone who follows my thinking, especially of late, many of our companies have been too liberal when it comes to the use of debt. While debt has its role in corporate finance, investors need to understand the role of debt in the companies in which they invest. In the case of WMT, they use debt to enhance the earnings power of a very large and mature company, which isn't too surprising. Additionally, they have been boosting EPS for several years by reducing share-count and have taken up the pace a bit this year. According to their most recent 10-Q, the company has repurchased $10 billion of stock since they authorized a $15 billion purchase over time on May 31, 2007, representing a significant premium to free cash flow after dividends. I'll come back to this point later, but I wanted to share this information initially in the event, like me, you weren't exactly fully sure how WMT was growing its EPS.

The issues I see with WMT fall into three areas: operational challenges, valuation concerns and a weak chart . WMT margins are pretty low (not a surprise given the nature of the business), but they have been stable for quite some time. Pre-tax margins have been 5%-6% roughly for the past 18 years.

Recently, they have been under moderate pressure and are near the low-end. The challenging economic environment could pressure them more significantly. Besides lower through-put with consumer demand flagging, customers could demand better pricing as piles of goods stack up at competitors that are either liquidating or in fear that they will be liquidated if they don't move as much inventory as possible.

Beyond pressure on the operating margin (which has moved from the high 7s to the low 7s already this year), the company could see challenges from higher potential funding costs as it moves its short-debt out. Finally, the company's suspension of its large repurchase program removes some of the EPS boost experienced over the past few years. I expect that EPS estimates, already down after the pre-announcement, could drop further and am predicting that fiscal 2011 will come in closer to $3.50 rather than the $3.98 consensus.

(click to enlarge)

While it is difficult to say that WMT is egregiously overpriced given its PE multiple of just 14.3X, that is a premium to the market for a company with below-market growth potential in the long-run. As I have been conveying, I have been paying a lot more attention to balance-sheet valuation metrics and would note that 4X tangible book value is no bargain in the event earnings do erode even worse than I expect. I believe that a year-end valuation for WMT consistent with this market would be 12X my FY11 estimate or 42. This represents a decline of almost 19%.

The chart (click to enlarge) indicates that the long-term moving average rolled over and served as resistance before the gap down. What's most concerning is that the stock has done so well against the rest of the market for the past two years that it has lots of room to be sold by institutional investors should they want to do so (before becoming a bad "relative" investment). Additionally, with an above-market valuation, there is little reason not to sell on that basis should one become inclined. Breaking 50 looks to be a potential catalyst for the next leg down, while the stock should struggle breaking 54.

WMT has been one of the few safe havens for large-cap investors over the past year. The fundamentals have shifted, and the company is vulnerable to this economic downturn even if to a lesser degree than others. Its balance sheet, which has seen tangible equity relative assets decline from 38% to 30% over the last 10 years, isn't nearly as pristine as it should be. The stock has rolled over now and appears to be on the edge of a potential sell-stop trigger. Its valuation isn't nearly low enough to support it through any further bad news at this point. While I am not short the stock, it seemingly supports my overall bearish views. I shared a forecast that stocks will fall 15-20% this year, which, if correct, means WMT will actually be slightly-worse-than-market performer should it end the year at my target of 42.

Disclosure: No position

Comments

[H.J. Huneycutt:]

Wal-Mart is somewhat overvalued right now, I would agree, but I don't think their debt is a concern at all. If they wanted to pay off their debt, they have high enough cash flows to do so relatively easily. Plus, unlike Target, Wal-Mart derives a substantial portion of their revenues from grocery sales (especially outside the holiday season), so while they'll suffer a bit, it won't be nearly as much as other retailers.

But you're right --- there are definitely better safety stocks out there right now if for no other reason than valuation.

Jan 18 02:25 AM

[prudentinve...:]

Alan, you are right. P/E of 14 is too high for a very mature, even though well-run business. Ditto for dividend yield <2%.

I'd rather see any company reduce a substantial debt load than buy back stock, but many prefer stock buybacks because of the disproportionately large, favorable effect on the value of the executives' stock options.

Jan 18 09:45 AM

[bill d:]

Excellent article - a few questions:

You say - In the case of WMT, they use debt to enhance the earnings power of a very large and mature company, which isn't too surprising.
How does this work ?

How much effect is the China connection having on WMT ?

Seems to me I recall when Sam touted the hell out of being, buying & selling American ???

Merchandising must be very good - you hardly ever see the big clearance, closeout, etc sales , the others have - except seasonal clothing & gardening stuff.

I've tried playing WMT options both ways and am always on the wrong side.

Thanks again for a very informative article.

Jan 18 11:00 AM

[Alan Brochs...:]

Thanks, Bill D...

The company generates a lot of cash, no doubt. This cash can be used in many ways: Reinvest in business, pay dividends, reduce debt, etc. A very mature company like WMT becomes challenged to reinvest efficiently, so typically it makes a decision to allocate this free cash into either reducing debt, paying dividends or buying back stock.

In the case of WMT, it has paid dividends and repurchased stock. Repurchasing stock helps EPS assuming the return on the stock exceeds that of cash (this is known as being "accretive" to earnings). Simply, fewer shares to derive the benefit of the total income. In the case of WMT, though, the share repurchases have been well in excess of the excess cash the company generates. The math there works similarly, except that one looks at the cost to borrow rather than the loss of interest. There is a cost to the remaining shareholders who don't sell: a reduction in book value per share (since the stock is purchased well above its equity valuation based upon historical accounting.

As far as China, I am not sure I understand your question. WMT, through its very aggressive purchasing requirements, has certainly led to a lot of off-shore manufacturing from China. This process has allowed WMT to remain a cost leader and grow market share.

On Jan 18 11:00 AM bill d wrote:

> Excellent article - a few questions:
>
> You say - In the case of WMT, they use debt to enhance the earnings
> power of a very large and mature company, which isn't too surprising.
>
> How does this work ?
>
> How much effect is the China connection having on WMT ?
>
> Seems to me I recall when Sam touted the hell out of being, buying
> &amp; selling American ???
>
> Merchandising must be very good - you hardly ever see the big clearance,
> closeout, etc sales , the others have - except seasonal clothing
> &amp; gardening stuff.
>
> I've tried playing WMT options both ways and am always on the wrong
> side.
>
> Thanks again for a very informative article.

Jan 18 12:33 PM

[{5U}:]

Alan, on a relative basis I think Walmart should outperform but I have found it to be a bit of a crowded "flight to quality" trade.

Is there anything you think is cheap from the long side? Debt or equity?

How are you playing this market?

Jan 18 02:06 PM

[Alan Brochs...:]

I have a few longs in investment accounts and am short (or trade short) via ETFs in trading accounts. You can always check out my holdings by visiting the disclosure on my website. I have written about many of the holdings on Seeking Alpha. I have 17 holdings currently. I most recently added ISRG, a company I have followed very closely for four years. I rode it nicely but exited too early due to valuation. My recent purchases are the first since I exited the name in 2007. I haven't written about that one per se, but the recent announcement jibed perfectly with my expectations. I see downside to 80 or so potentially, but I believe that the earnings picture won't be as bad as many of the analysts have presumed. My other recent purchase is a very small auto parts company with a strong balance sheet, DORM. Hardly trades, but it's very cheap (close to tangible book) and a much better play on one of my favorite themes (extending automobile ownership periods) than ORLY/AAP/AZO etc.

As far as the rest, many are trivial in size for now. The largest names are CHSI, CRMT, EZPW, HRL, SCVL and THO. I am positioned primarily with small companies trading at very stressed valuations relative to book value with strong balance sheets and either the potential to grow or to at least hang in.

Jan 18 02:17 PM

[Analyst's a...:]

WMT will surge as institutional analysts, those not let go, are worthless when attempting to predict a stocks market trend! It will trend up for a number of reasons.

Jan 18 04:50 PM

[{5U}:]

Interesting. I noticed most of your stock longs have clean balance sheets.

My general theme this year is to long credit and short stocks of companies that are levered and/or rely on cheap credit or simply have high valuations that do not match the growth.

Here are my short candidates I trade around: AYI, DRYS, AAPL, WYNN, JBLU, FLEX, XHB, SRS, SLG, PSA, SPG, PLD,SHLD

I covered most of these except for the REITs which I know can get short squeezed on the Hope and Change Rally, but am willing to take the pain.

I have a small amount of equity long exposure, like CMCSA, CHK and APC. And long some Hope and Change Hedges, like TBT and BGU. And yah...started a position in PFF.

You should look more at credit With leverage reduced at the hedge funds, converts are a bit of an oprhan asset class right now. Long a bunch of single names s in the investment grade, high yield and converts and long some credit funds. Leveraged loans are dirt cheap.

Jan 18 05:15 PM

[Alan Brochs...:]

"You should look more at credit With leverage reduced at the hedge funds, converts are a bit of an oprhan asset class right now. Long a bunch of single names s in the investment grade, high yield and converts and long some credit funds. Leveraged loans are dirt cheap."

I think that what you are pursuing makes a lot of sense, but it tends to be a market more available to institutions from what I have gathered. I would throw GE and T/VZ into your bucket of shorts. I have recommended to a client several shorts, one of which I think is a fantastic one that I wrote up on Seeking Alpha recently: WTW. On the long side, preferreds from companies that have low debt/cap ratios are very attractive. PSA comes to mind, but there are a few others.


On Jan 18 05:15 PM Equity Has No Clue wrote:

> Interesting. I noticed most of your stock longs have clean balance
> sheets.
>
> My general theme this year is to long credit and short stocks of
> companies that are levered and/or rely on cheap credit or simply
> have high valuations that do not match the growth.
>
> Here are my short candidates I trade around: AYI, DRYS, AAPL, WYNN,
> JBLU, FLEX, XHB, SRS, SLG, PSA, SPG, PLD,SHLD
>
> I covered most of these except for the REITs which I know can get
> short squeezed on the Hope and Change Rally, but am willing to take
> the pain.
>
> I have a small amount of equity long exposure, like CMCSA, CHK and
> APC. And long some Hope and Change Hedges, like TBT and BGU. And
> yah...started a position in PFF.
>
> You should look more at credit With leverage reduced at the hedge
> funds, converts are a bit of an oprhan asset class right now. Long
> a bunch of single names s in the investment grade, high yield and
> converts and long some credit funds. Leveraged loans are dirt cheap.

Jan 18 05:21 PM

[damonleo:]

I agree with everything you noted in your analysis.However, the bottom line will come down to whether WMT keeps up the pace with it's number projections. If WMT disappoints again the market is going to whack them down to the mid 40's. The proof will unfold in february with it's monthly numbers on the 5th and 4th quarter on the 17th. I would assume they will make a projection on future earnings during one of these announcements. I have been successfully trading WMT options for months, however I was taken to the woodshed on the 8th with their disappointing numbers. I took my flogging(thank you sir, may I not have another). I am apprehensive in taking a position as I am waiting to see what direction WMT is heading along with establishing a more definitive trading pattern. Also, the premiums on the options have been so volatile with strength and weakness changing day to day. I expected WMT to rebound to $54-55 which to date has not materialized. I believe the new trading range is $54-55 as the top for WMT with 50 as the bottom, unless the market craps out below 8,000, then 47-48 is the next step down.

Jan 18 10:40 PM

[Jake2:]

Walmart is such a holy cow for some investors it is refreshing to get a disinterested look at it once in a while. The current chart. as any jaundiced eye may discern, is pretty much a disaster.

Jan 19 01:03 AM

[bill d:]

Thanks for the response Alan - I think I get it.
My instincts are telling me to go buy calls on WMT but then a little voice in my head says buy puts. Bad enough my decisions are always wrong on WMT - even my brain is confused. LINE is looking good - maybe I'll jinx them !

Jan 19 01:16 PM