Goldman Sachs' Downgrade of Wal-Mart Incorrectly Favors Discretionary Retailers

In what appears to be a downgrade based mostly on a macro call for economic recovery, Goldman Sachs (GS) downgraded Wal-Mart (WMT) stores Monday from “buy” to “neutral” and lowered the price target on the stock to $56 from $58. While I have not been able to locate the full text of Goldman’s report online, the Wall Street Journal published a couple of excerpts which I have referenced in this article.

Goldman Sachs is advising clients to shift to retailers that sell products that are more discretionary in nature suggesting that economic growth may return in the second half and implicitly suggesting that consumers will return to old habits. Here is an excerpt from the Goldman Sachs report courtesy of The Wall Street Journal:

We expect more discretionary retailers to display significantly greater relative EPS momentum vs. Wal-Mart into 4Q2009 as the former lap easy year-ago margin comparisons. As this fundamental performance gap closes, we believe investors will look to rotate into less staple-like names to take advantage of a recovering retail sector. This could cause WMT’s valuation to stall in the near term, thereby stymieing relative stock performance.

It is worth noting that this logic does not discuss Wal-Mart’s intrinsic value or long term growth prospects but instead fixates on short term factors such as earnings momentum and year over year comparisons. Unfortunately, this type of thinking is par for the course on Wall Street and should be disregarded by investors seeking to build wealth over the long term.

Wal-Mart stock has stagnated for over a decade as the valuation assigned by the market has compressed while earnings have steadily marched ahead, as discussed in an article posted on this site in April. In retrospect, it is clear that the stock market assigned a very rich valuation to Wal-Mart ten years ago. The open question is whether the current valuation, which is close to a record low for Wal-Mart, can be justified based on growth prospects going forward. The only question that investors should ask is whether the stock's price is at a significant discount to a conservative calculation of intrinsic value, not whether EPS momentum will continue next quarter or how year over year comparisons may appear.

Although obviously anecdotal in nature, I have seen firsthand evidence of trends that many others have written about in recent months related to the growing trend toward “thrift” in America. Wal-Mart’s parking lots appear as full as ever and more expensive cars have been making an appearance as well. Whether these more affluent shoppers will retreat into old habits once the economy turns around is an open question. However, given that the current economic dislocation is the most severe since the Great Depression, it seems doubtful that thrift will be out of fashion anytime soon.

Most of us know older relatives who grew up during the 1930s and retained their “cheap” habits throughout their lives. History does not ever repeat exactly, but the current open economic wounds afflicting millions of Americans will not just disappear once the recession ends. They will remain as scars for a long time to come – reminders of the fact that thrift simply makes sense. Wal-Mart is uniquely positioned to capitalize on this trend.

Disclosure: The author owns shares of Wal-Mart Stores.

Comments

[H.J. Huneycutt]

Honestly, I don't see much of a point in buying into Wal-Mart at this stage. I'm neutral on it, as well.

All the same, I don't agree with Goldman Sachs' reasoning. I can understand buying into a discretionary retailer if its intrinsic value is much higher than the stock price, but I wouldn't make wholesale recommendations in favor of buying them. It's also worth considering that most of the discretionary retailers have already had a considerable run-up at some point over the past three months.

The retailers I like the most are the ones the market believes to be "discretionary", but in reality, are less discretionary than it might seem. Hot Topic (HOTT) is a good example to me. They mostly sell cheap apparel targeted at teenagers and young adults within a certain alt-pop niche. I don't forsee Americans shifting to a lifestyle without clothes any time soon, so clothes are still a necessary item. The main factor that separates a "necessity" from a "luxury" is cost.

However, price is still the most important factor to me when buying a stock. I'll buy a luxury retailer if the current price reflects a "worse than the Great Depression"-type scenario and I believe the retailer will survive based on the fundamentals.

2009 Jun 17 09:04 AM

[square to the shooter]

I recently attended the Morningstar Conference in Chicago where the A list of money managers have astute yet differing outlooks for the economy. Bill Gross's "New Normal" view sees 7% to 8% inflation as normal as opposed to the 4% we were used to prior to this recession. Jeremy Grantham sees a sustained age of frugality that wil continue for many years to come. I have been a shareholder of WMT for several years and have a significant unrealized loss. However, I still like WMT going forward. I'm in accordance with Grantham that consumers will be more frugal for many years to come. Additionally, WMT has invested signifciant capex into upgrading their stores. The result is a shopping experience that is less "big boxy" and has more "lifestyle" feel. In my opinion, they've significantly closed the gap on their homewares, toys, outdoor and electronics sections vis-a-vis their competitors. The staycation dollar has some merit, albeit below the level of recent hype.

Non-normalized P/E's are overused as a value measure. For a more detailed analysis, consider looking at free cash flow ( gross cash flow less changes in working capital and capex), and the growth thereof. Even though everyone is talking green shoots, dont forget about balance sheets. And while you are at it, dont forget non balance sheet obligations like pensions and lease obligations that are only found in the notes. Consider the probability or certainty of growth in FCF of WMT versus a HOTT (as cited above) or a TIF.

But if you must consider P/E's, I recommend doing it through the lenses of a paramutel system. Consider these TTM P/E's

WMT 14.5
HOTT 14.2
SHLD 57
LOW 13
TIF 18
COST 18.5
WAG 15


Ladies & Genteman, pick your horses!

Disclosure: I own WMT (obviously) , COST &WAG

2009 Jun 17 10:38 AM

[sarge 907]

I wish I had held the WMT stock I inherited in the eighties, then I could also complain about losing money.

Are you kidding or just plain dumb? Me, I was dumb, dumb, dumb.

2009 Jun 17 10:59 AM

[Old Trader]

As an aside, there might be some competition ahead for WMT coming down the pike. Tesco (?), a large UK-based discount retailer is eyeing entry into the US market. Of course, its also my understanding that WMT is expanding overseas. (Full disclosure: I have no dog in this fight).

2009 Jun 18 10:30 AM