How to calculate Owner Earnings for Wal-Mart (WMT)
This is the second part of "Reading between the lines of Wal-Mart's accounts". Read the first part of the analysis here.
According to Warren Buffett, when analyzing a company, an investor should focus on the earnings a 100% owner of the business would pocket at the end of the year. Furthermore, value investors should not overpay for growth (as the future is always uncertain) and focus instead on the steady state earnings of a company.
In his 1986 Letter to Berkshire Shareholders Buffett explains that Owner Earnings represent:
Reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges.
The average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
In the first part of our analysis we have already seen that a huge part of Walmart's stated capital expenditures goes into growth investments. This would require an adjustment, as these investments are not required to fully maintain its long-term competitive position and its unit volume.
Another detail we stumbled upon relates to inventories: They grow every year, as Walmart expands its store network. Yet in the cash flow statement, every increase in inventories reduces operating cash flow. In turn, however, there is an increase of accounts payable which increments operating cash flow again.
Comparing today's inventories with those of 1998 reveals a difference of roughly $27 billion, while accounts payable increased by about $28 billion over the same period. Hence, over longer periods of time these two seem to balance out and should not require adjustments to our steady state cash flow estimate.
Well, much ado about nothing? Yes - and no, as there is another conclusion to draw from this little exercise: If every increase of inventories gets totally offset by an increase in accounts payable, Walmart can fill its shelves without paying a dime out of its own pockets! It's the suppliers that finance Walmart's expansion and the concept of "float" comes into mind.
Warren Buffett calls "float" the money insurance companies receive upfront as premiums and pay out later, when claims arise. While the insurer waits for the claims, he can invest the float, and if he underwrites profitably, we will not only have enjoyed holding free money for a while but will ultimately even get paid for it. (To understand more about Warren Buffett's concept of "float", read this article.)
By building up inventories, Walmart basically gets free money. About 1/3 of Walmart's total liabilities are held in the form of free money. This clearly is a competitive advantage.
Walmart itself does not consider this money to be invested. Look here:
In the calculation of the return on investment ratio, Walmart deducts the accounts payable from the total capital invested. Now we understand why. It's a free loan.
Finally let's return to our cash flow calculation.
In the annual report we can find the following allocation table:
This is astonishing: We can estimate that in the US Walmart spends only half of its total capital expenditures for maintenance; hence in the international segment the proportion should be much less balanced. In the US the number of stores increased by only 3.5%, whereas internationally it grew by almost 9%. A reasonable estimate could be that in 2013 of $12,898 million at least $4 billion were spent for expansion in the US and $3 billion internationally, thus only $6 billion remain for maintenance, which is actually less than the amount of $8.5 billion deducted for depreciation and amortization.
We can now calculate Owner Earnings as follows:
Operating cash flow as stated (2013)
Pre-opening costs (see Part I)
+ $316 million
Tax gain on pre-opening costs
- $108 million
Adjusted operating cash flow
- $6,000 million
Adjusted free cash flow (Owner Earnings)
Owner Earnings per share
Now we know that Walmart's steady state earnings in 2013 were 16% higher than stated GAAP-earnings. Over time, if the company continues to slow down growth investments, GAAP-earnings will come closer to Owner Earnings (providing maybe a catalyst to move the stock higher), but who cares after all? We already know that Walmart earns this money now and can spend it at its own discretion, e.g. for dividends, buybacks or expansion. And we have also learnt (in Part I) that the company is totally focused on receiving high returns on capital, whenever it invests its equity.
All this is only a small part of the insights a careful analysis of financial statements can reveal. If you have been an attentive reader, you might also have noticed how our knowledge and confidence in this knowledge get strengthened through the very process of analysis. And we haven't looked at a company presentation or price chart yet. However, we now have a very precise and solid picture of the company and its business model.
In the third and last part of this analysis we will try to figure out the fair value of Walmart's shares. Keep in mind that the $5.84 of Owner Earnings per share represent only one year and cash earnings typically are by far not as steady as GAAP-earnings. Furthermore, we still haven't answered a few questions yet:
- Why does Walmart deliberately cannibalize sales of its own stores?
- How much earnings growth can we expect in the years to come?