Wal-Mart (WMT) is the largest retailer in the United States in terms of market capitalization and revenues. Given the size of large-cap retailers like Wal-Mart, growth in revenue and earnings is limited because of decreasing marginal returns to capital. Smaller companies such as Costco Wholesale (COST), Family Dollar (FDO) or Dollar General (DG) offer investors more upside due to their higher sensitivity to incremental consumer spending. Wal-Mart achieved $469 billion in sales in 2013 (fiscal year ending in January) and it is much harder to grow from such an elevated level. Shares of Wal-Mart's smaller competitors in the discount retail sector have therefore performed much better during the economic recovery in the United States. Although Wal-Mart is 43% since 2009, conservative investors can still access a great dividend stream at a decent free cash flow yield.
Historical free cash flows
Wal-Mart has grown operating cash flows consistently over the last four years and the continued recovery in US consumer spending suggests that operating cash flow trends continue. The United States has a lot of room to grow: Unemployment is still high at 7.3% in August, interest rates are still near zero, home prices and salaries/wages have substantial upside as the US economy expands. Even tapering actions from the Fed will be a big positive for companies and stocks in general. As I have said before: The time to be in stocks is now. Tapering does not matter. Bears argue that tapering is not good for the economy and stocks in particular. I disagree: The Fed, after years of pursuing a lose monetary policy which provided Corporate America with low financing rates, will soon begin to taper because the economy is strong enough to grow by itself and does not need to be on life support any longer. This is a good sign for stocks and Wal-Mart should profit from higher consumer spending as employment increases and the wealth effect kicks in. The wealth effect basically suggests that once people feel richer (based on a better job picture, rising house prices, rising stock prices) they will spend more which benefits the retail sector among others.
Below I have compiled the operating cash flows and core capex data from Wal-Mart's latest 10-K. I estimate cash flows to grow at the historical rate with free cash flows to equity rebounding to $18,370 million driven by higher net borrowings. In the first six months of 2013 short- and long-term debt increased by $3,809 billion which validates the assumption of higher debt in my 2014 FCFE forecast. The 2014 estimated FCFE stands at $5.56 giving investors a 7.63% free cash flow to equity yield based on a current share price of $72.80.
Given the large revenue base Wal-Mart operates from, growth in earnings and free cash flows is limited and I estimate Wal-Mart to be able to achieve a long-term FCF growth rate of 3%. Details of the intrinsic value calculation based on Wal-Mart's estimated 2014 FCFE of $5.56 per share are provided below:
Peer group valuation
In terms of market valuation, Wal-Mart remains a bargain at 12.73 forward earnings. It is probable that the market prices lower sales and earnings growth into Wal-Mart's shares. Lower-cap companies Costco and Dollar General operate from lower sales and earnings figures which makes higher growth rates easier to achieve. In any case, investors purchase Wal-Mart at a 7.9% earnings yield which limits downside risk while improving consumer spending provides tailwinds for Wal-Mart's business.
Wal-Mart offers the highest dividend yield of 2.58% of the firms under review. Since 2011 Wal-Mart has increased its dividend by a compound annual growth rate of 14.6%. For the first six month of 2013 Wal-Mart has declared a dividend of $1.88 per common share which is sufficiently covered by an underlying FCFE per share of $5.56.
A summary of valuation metrics as well as discounts/premiums to the peer group average P/E, Enterprise Value/EBITDA, PEG and dividend yield is provided below:
Wal-Mart has stable operating cash flows that are likely to grow moderately as consumer spending in the US recovers in lockstep with the economy. The free cash flow valuation suggests that Wal-Mart shares still have room to go up another 10%. Conservative investors who look for free cash flow covered dividends and who seek exposure to the retail sector might want to consider an investment in Wal-Mart at an initial earnings yield of 8% and with prospects of even higher dividend yields in the future.