- After Goldman Sachs downgraded Wal-Mart in recent weeks, this time it is Jefferies' turn.
- Lack of growth, increased competition and margin pressure might hurt earnings further going forwards.
- A small discount to the overall market valuation is warranted amidst lack of growth, the reasonably high debt position, anticipated margins pressure and bad publicity.
Shares of Wal-Mart (NYSE:WMT) faced a bit of pressure at the start of the trading week after analysts at Jefferies downgraded the stock ahead of the second quarter earnings release on Thursday of this week.
I share most of the cautiousness displayed among analysts given the slowing growth, pressured earnings and momentum in the shares in recent years. Combined with the structural problems at the business, the bad publicity and reasonably high debt position, I see few triggers for a quick turnaround.
Jefferies Turns Cautious
Analyst Daniel Binder who works at Jefferies downgraded his rating for Wal-Mart from a Buy to a Hold recommendation. At he same time he lowered the price target by thirteen bucks to $76 per share, roughly in line with the current stock price.
Binder believes that expectations for the second quarter are already quite low. That being said, after closely listening to management's comments about investment spending, higher expenses and disappointing sales, a disappointing full year earnings number might be in the make.
Consequently Binder thinks it is not very likely that the midpoint guidance for earnings of $5.28 per share, or the street consensus estimates at $5.17 per share will be achieved. Jefferies has lowered the earnings per share estimate for the fiscal year of 2015 from $5.72 per share to the low end of the company's own guidance at $5.10 per share.
A Tough External Environment
Binder furthermore acknowledges that Wal-Mart and other discount retailers, such as Target (NYSE:TGT), operate in a very difficult environment. This is as the low income customer has seen tough times for years, not having recovered from the recession which started over five years ago.
Wal-Mart's response to increase spending and investments in terms of prices, and the e-commerce business has resulted in lower margins in what is already a very low margin business. The company's plan to expand into the small neighborhood format might also not be a very smart move given the competition from dollar stores which is fierce. This follows consolidation in that area after Dollar Tree's (NASDAQ:DLTR) purchase of Family Dollar (NYSE:FDO).
Jefferies is not the only firm being cautious on the prospects for the company after analysts at Goldman Sachs downgraded the company by the end of July. Analysts at Goldman suggested that customers flee the big-box retailer for more focused assortment stores and online shopping venues, including Amazon.com (NASDAQ:AMZN) of course.
A PowerHouse In Stagnation
Wal-Mart's long term growth story has been impeccable, but in recent times sales have been stagnating despite a recovery in the US overall economy. Over the past decade, sales have grown from $288 billion in 2005 to $477 billion on a trailing basis, thereby growing at a compounded annual growth rate of a around 5%.
Earnings have grown at nearly the same pace to $15.8 billion on a trailing basis, after annual earnings peaked at $17 billion in the fiscal year of 2013. It should be noted that long term investors have benefited from sizable share repurchases as the company retired roughly a quarter of its share base, at a rate of about 3% per annum.
With first quarter sales increasing by just 0.7% on an annual basis, inflation implies that actual volumes being sold are most likely down. This makes it very difficult to keep profits at current levels, explaining the 5% drop in year-over-year earnings.
The interesting part is the divergence in terms of operational performance and the stock price. While growth in revenues has been slowing down over the past 3-4 years from the historical averages, this was the time when the stock broke out to new highs. Since the year 2000, shares have traded in a $40-$60 trading range, breaking out towards a $60-$80 range by the middle of 2012.
This has actually made the valuation a bit more demanding with shares trading around 16 times earnings assuming that Wal-Mart posts profits of $15 billion per annum. The company's net debt position has steadily increased as the company has grown or actually outpaced growth in topline results. This occurred as the company resorted to increase dividends and a more rapid pace of share repurchases to please investors. The net debt position just shy of $50 billion equals roughly three years of net earnings.
Back in May, I last had a look at the prospects for Wal-Mart after the company posted its first quarter results. While I liked the bright spots including the e-commerce business and the neighborhood store format, the positive impact from this was too limited to make a dent in its operations.
At the same time, the company has seen very bad publicity including the global bribery scandal, poor wages of its workers and reliance on the government indirectly through food stamps for example.
I also noted that the company has slowed down the pace of share repurchases from an historical 3% average per annum over the past decade to about 1% per year now. This provides much less support to the share price. I must say that the 2.6% dividend yield is appealing, especially in the light of this lower interest rate environment.
As such the 10-15% discount to the general market at 15-16 times earnings is probably deserved as the debt load does not allow for much greater shareholder payouts now. Furthermore the growth is suboptimal while the huge employment base leaves the company vulnerable to some extent to often demanded wage hikes.
I remain on the sidelines for now. I will watch Thursday's earnings release with a great deal of curiosity.