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Summary

  • Same-store sales were flat in Q1 due to a loss in food stamp revenue and poor weather conditions.
  • However, same-store sales for smaller-format stores grew 5% and e-commerce sales grew 27%.
  • These may seem like hard times for Wal-Mart, but it's only temporary. A comprehensive plan is in place and relief is on the way.

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Source: Warren Buffett, Letter to shareholders, 1989

Large box retailers have had a difficult time over the past 16 months. Big Lots (NYSE:BIG) announced its eighth consecutive quarter of declining same-store sales and Target (NYSE:TGT) is looking for a new CEO more so due to declining same-store sales than a data breach. Wal-Mart's (NYSE:WMT) had a difficult time as well and with the latest earnings announcement many analysts are jumping ship.

Six months ago, I too had concerns about Wal-Mart, but that was before Doug McMillon took over. In the article 3 Reasons Why Wal-Mart Is In Trouble, I provided an argument for why the company was headed for trouble. Wal-Mart's main issue, however, isn't labor, minimum wage, or international bribery, but same-store sales. At the time there were no real solutions on the table, but then the miraculous happened -- the company decided to accelerate its small-store format expansion.

Wal-Mart's new CEO, Doug McMillon, started working for Wal-Mart as an intern in the distribution center. When McMillon took over as CEO in February, he made a bold step by accelerating the company's growth into small-store formats -- particularly in urban areas. This one move has the potential to supercharge earnings without cannibalizing the company's current market share. Growth at these smaller stores is higher because it's based on the economics of convenience rather than price alone. Bill Simon, head of U.S operations, had this to say about the small format business model on the last call:

Neighborhood Markets continued to deliver consistent[,] solid comp sales growth, and customers appreciate the convenience of our small stores. They are a proven model.

So, while many analysts are advising investors to hold or sell, smart investors are looking at this as a buy opportunity.

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down."

Source: Warren Buffett, Letter to shareholders, 2008

At its current price of $77.01, given an industry P/E of ~19x, and earnings of $5.08, the company should be trading at $96.52 which is a 25% premium to the current price.

Q1 performance

"We expect first quarter fiscal year 2015 earnings per share from continuing operations to be between $1.10 and $1.20," said the company on the Q4 earnings announcement. Earnings actually came in at $1.10, which is at the bottom of its earnings guidance and -4.30% below consensus estimates.

Wal-Mart also expected same-store sales growth to be flat for the 13-week period ending May 2 compared to the 13-week period ending April 26, 2013. Last year Wal-Mart's comp sales declined 1.4% and this year they were flat, which is an improvement, albeit slight, over last year. This is very encouraging and I think we'll start to see more improvement in same-store sales as the year progresses, certainly by this time next year.

Another issue in Q1 was margin. McMillon had this to say about operating expenses:

Wal-Mart's first quarter net sales increased 0.8 percent over last year. Like other retailers in the United States, the unseasonably cold and disruptive weather negatively impacted U.S. sales and drove operating expenses higher than expected.

The main takeaway here is that the decline is weather related; it's temporary in nature. It also sets the company up very well for growth in Q1 of next year as it comps over this year.

So, now I offer three reasons why Wal-Mart is not in trouble.

1) While same-store sales as a whole were flat, same-store sales for smaller-format stores grew 5%. According to the company, "April marked the 46th consecutive month of positive comps for Neighborhood Market[s]." Wal-Mart is accelerating its small-store format expansion efforts and plans to open 270-300 small stores by the end of the year which should greatly improve comps in Q1 of next year.

2) E-commerce sales grew 27% and according to Wal-Mart e-commerce sales positively impacted comp sales by 0.3% last quarter.

3) Perhaps the most interesting development is operating margin. Last year, according to the Q4 earnings announcement, operating margin results were flat for the US, but dismal for International, which declined by 45.8%; Sam's Club's fell by 15.3%. David Cheesewright, president of Wal-Mart's international segment, had this to say about the decrease :

The combination of soft sales, price investments, higher expenses, and investments in e-commerce caused [Wal-Mart international's] operating income to decrease on a reported and constant currency basis.

Wal-Mart International and Sam's Club represent 29% and 12% of the company's revenue, respectively, or 40% combined. An improvement in International and Sam's Club operating margin can have a real impact on the bottom line. So what's the good news, last year International's operating income declined by 4.7% for the full year compared to a 3.4% increase in Q1. What's more, the improvement appears to be more permanent than temporary.

Conclusion: Wal-Mart's on the operating table

The best thing that happens to us is when a great company gets into temporary trouble...We want to buy them when they're on the operating table."

Source: Warren Buffett, Businessweek, 1999

The bad news is that same-store sales are flat primarily due to a loss in food stamp revenue, which is only going to get worse as additional cuts take effect. The good news is the company has identified the problem and is implementing a comprehensive solution which involves smaller store formats, more convenient store locations in both rural and urban locations, a larger organic offering and a continued focus on increasing e-commerce revenue. Additionally, operating margin declines in the US are temporary whereas International gains appear to be permanent.

These may seem like bad times for Wal-Mart, but it's really a company in transition. Wal-Mart may be on the operating table, but it's in good hands and next year it should be in full recovery.

Source: 3 Reasons Why Wal-Mart Is NOT In Trouble