As Wal-Mart's (NYSE:WMT) comparable store sales have deteriorated, the stock has been priced down to a bargain level when its economic muscle and brand strength are properly evaluated. The company continues to invest in growth, some of it reflected in cash flow as capex, and some passing through the income statement as expenses.
Investing in Price
Reading 2Q 2015 earnings call transcript, I was struck by the repetitious references to the concept of price investment, as well as the assertion that the company is "investing" in staffing and leadership. From an accounting viewpoint, these are expense items. However, the entrepreneurial mindset sees them as investments that will generate future income, and in effect capitalizes them.
Specifically, I counted 11 references to "price investment" or variants thereof. That includes 2 instances where the cost was quantified in basis points.
What I see is a focus on maintaining the brand's strength as the perceived low cost provider of a multitude of products. They attempt to achieve this by being consistent, and in point of fact they ate some of the increased cost of meat when prices spiked. They believe that shoppers eventually tire of the games supermarkets play with pricing.
I was vehemently critical of Darden's (NYSE:DRI) CEO when he talked about investing in price at Red Lobster. I felt the endless AYCE promotions had cheapened the brand. I've seen a couple of retailers get in trouble by trying to avoid promotions and discounts in for example clothing or other seasonal items.
After thinking about this for a while, I'm proceeding on the basis that for Wal-Mart price investment creates customer loyalty, and is part of its strength as an iconic brand. It's how they got to where they are today. With that in mind, I don't think small fluctuations or decreases in margin are cause for undue concern.
Investing in Staffing and Leadership
In March last year, Bloomberg published an article asserting that certain Wal-Mart stores were so thinly staffed that the merchandise wasn't making it onto the shelves, and customers were going elsewhere. Evidence was anecdotal, but had a ring of credibility.
The conference call linked above includes a mention of investments in additional hours:
Operating income was pressured by investments in additional associate hours and by higher healthcare costs. We'll keep working during the back half of this year to get the combination of price investments and store associate hours right to deliver improved comp sales and serve our customers in a way that exceeds their expectations here in the U.S.
During the quarter, we also allocated additional associate hours to specific areas of the store, such as front end, deli, bakery, and overnight stocking to improve overall customer service. We also sustained incremental labor expenses related to major department re-lays in entertainment and sporting goods. In total, salaries and wages were up more than $200 million compared to last year.
The previous quarter's call includes a discussion of corrective action in terms of additional staffing:
In October, we communicated that 90% of our supercenter fleet was performing well. In Q1, these stores delivered a positive comp and improved over Q4 last year. For the remaining stores that require special attention, we've developed unique, store-specific action plans and we're investing in leadership and additional staffing.
Management is responding to the issue, and adding employees or increasing hours where necessary.
Home Depot (NYSE:HD) had inadequate staffing levels under the leadership of Bob Nardelli, and profitability was severely impacted. Frank Blake was brought in to turn the situation around. He correctly identified the problem, added an appropriate number of employees, and results improved substantially.
Wal-Mart's previous margins may have reflected inadequate staffing. As such, they may have been unsustainable. Somehow it sounds better to think of additional associate hours as an investment. In any event, corrective action is being taken.
Capex, as a percentage of revenue, has decreased from 4.48% to 2.58% over the past 10 years, reflecting reduced growth opportunities in the big box bricks and mortar category.
Investments are focused on e-commerce, to include a new distribution center, and small format stores, where $600 million was deployed to accelerate the roll-out.
TTM ROE at 22.1% and ROIC at 13.6% demonstrate profitable deployment of capital. Both figures are consistent with 10 year averages. There is every reason to expect that current investments will be equally profitable.
Over the past 5 years, Wal-Mart has traded at an average PE5 of 15.33. Calculating 5 year average EPS, share count adjusted, at $4.96, I multiply by 15.33 and arrive at a fair value of $76. As such, recent prices in the $74 area may be regarded as normal.
A recent article in Bloomberg mentions that the S&P 500 is trading at a multiple of 21 on 5 year average earnings:
While analysts surveyed by Bloomberg expect earnings to expand by more than 8 percent a year through 2016, Ramsey at Leuthold said investors should prepare for profit growth to have less of an impact on prices. Using a formula that smoothes out income over five years, the S&P 500 is trading at a price-earnings ratio of about 21, his data shows.
I didn't do the math, but 21 sounds about right. So, with a beta of .37, WMT trades at a 29% discount to the index, based on 5 year average EPS.
Meanwhile, the dividend yields 2.5% and has increased steadily over the years, while share counts have been declining about 2.5% per year over the past 10.
Buying at recent prices in the $74 area, investors can reasonably expect an increasing flow of dividend income and eventual share price appreciation. The valuation is attractive on a risk-adjusted basis, when compared to the S&P 500 index.
The company faces headwinds, but management is aware of the difficulties, has a plan of corrective action, and the resources to carry that out. The situation should be monitored quarterly with attention to comp sales, e-commerce growth, success with new formats, and success in turning around the 10% of under-performing stores.
Disclosure: The author is long WMT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.