By Brian Sozzi
Seemingly out of left field, Wal-Mart (WMT) announced a proposed $4.76 billion all cash offer for South African retailer MassMart. Nowhere, to the best of our knowledge, has Wal-Mart publicly disclosed intent to tap into South Africa, a country that had a 20% plus unemployment rate and high-single digit percentage inflation rate in 2009.
Recently, discussions by Wal-Mart executives have centered on looming inflation in the supply chain, the challenged US consumer, and the throwing of cold water on the impact of recent management changes in the US division. So, we, as well as the market (stock is lower on the news), were surprised by the announcement to utilize almost $5 billion in cash. We can't say that Wal-Mart has swooped in to take advantage of a distressed opportunity as $4.76 billion in cash is no pocket change, even for the world's largest retailer, which generated $14 billion in free cash last year.
That said, while the proposed purchase price, which may rise above $5 billion if MassMart's CEO has his way, would bring certainty of value to that particular shareholder base, we believe no such certainty for Wal-Mart shareholders is obtained by adding MassMart to an already extensive international portfolio of assets.
First, MassMart is a collection of properties, built up through years of acquisitions since its inception in 1990 (the buying spree explains why operating expenses are running at a faster pace than top line growth). MassMart even operates a no frills home improvement business! Wal-Mart would likely leave MassMart's management intact (if they are inclined to stay aboard), but still, integrating such a diverse platform into Wal-Mart's operations will divert the attention of the international team (as a side note, with each mention of the international opportunity in presentations, and purchases outside of the US, Doug McMillan, CEO of International, inches closer to eventually leading the retailer). This is unfortunate as Wal-Mart has been operating rather well in the UK, for example, and has finally gained traction in the difficult Japan marketplace.
Second, Wal-Mart noting MassMart's margin profile as being "low" does not tell the entire story. MassMart generated a gross margin of 18.1% in the fiscal year ended June 2010, up slightly year over year, with an operating margin of 3.92% versus 4.51% a year earlier. Though MassMart would benefit from the Wal-Mart know-how and its best of class supply chain, the margin structure is well below Wal-Mart at around a 24% gross margin and a 6% operating margin. In other words, Wal-Mart has quite a bit of work to do just to bring margins up to the company average and then drive higher outcomes; keep in mind the South African retail marketplace appears highly competitive, maybe becoming more so if Wal-Mart decides to undercut competitors further on price as it does in the US.
Other Questions That Arise:
- Is this announcement designed to draw investor attention away from a struggling US business?
- Does Wal-Mart articulate a slower pace of share repurchases and dividend increases in light of the outflow of nearly $5 billion in cash?
- Should Wal-Mart be going full bore at turning around the US and developing the urban store opportunity instead of entering an entirely new market?
We are negative on this deal. Our opinion is that Wal-Mart should be allocating its capital first and foremost to developing US urban stores and then returning cash to shareholders through share repurchases and dividend increases. Moreover, the company should be articulating its strategy to investors for turning around the US, which is being attacked by Target (TGT), grocery stores, and dollar stores, as well as bringing aboard new talent to the US division.
Disclosure: No positions