- Wal-Mart's operating margins are tiny.
- Their asset turnover is remarkable.
- The use of debt is great.
- The quality of products underlying the business model just aren't good enough, despite how well the operations are financed.
Wal-Mart (NYSE:WMT) hasn't done so hot over the last 21 months. Since 2013 started the stock has risen 9.37% and paid out $3.32 in dividends per share. It isn't a bad dividend yield, but the company has been thoroughly outperformed by the S&P 500. The following chart demonstrates that performance:
To get a better feel for what went wrong with the stock, I'll run it through a DuPont analysis. The DuPont analysis isn't a forward looking tool, it relies entirely on previous financial statements. However, it gives us more context with which to interpret the current events.
Table 1 contains all the metrics calculated in the DuPont Analysis.
The tax burden for the company represents how much of their income before taxes makes it down to the net income line. The effective tax rate looks pretty high for Wal-Mart, but I've included a couple other factors that come between income before taxes and their net income. Specifically those items are gains and losses from discontinued operations and the effects of non-controlling interest.
Impact of discontinued operations
Discontinued operations have had a relatively small impact on the financial statements for Wal-Mart. The discontinued operations have regularly accounted for less than one percent of net income. The vast majority of Wal-Mart's statement consists of recurring items.
Impact of non-controlling interest
Non-controlling interest has been a significant factor in establishing such a high tax rate in the DuPont analysis. Technically, non-controlling interest is not a tax. However, it functions very similar to a tax. Each year it will take a certain percent of the income generated from segments that contain non-controlling interests. Taxes can also vary by segment, so the impact of non-controlling interest on income most closely resembles a tax.
Included in the calculations are the impact of capital leases and interest paid on debt. Interest income is netted against interest expense. By including capital leases and using the net interest expense, we find, in my opinion, a fairly accurate estimate of the cost of the debt Wal-Mart is using to finance operations.
Similar to Tax Burden, this line indicates the amount of income that will survive the impacts of net interest expense. Wal-Mart is getting around 90% past this line, which represents a fairly reasonable level of debt. Many large companies have less interest expense relative to their EBIT (earnings before interest and taxes), but Wal-Mart is using debt more aggressively. I agree with Wal-Mart's decision to use the debt this way. Even though the company didn't have a great couple of years, they are still making the right calls on how to leverage their operations to provide better returns to the shareholders.
The operating margin for Wal-Mart has been dreadful. It is incredibly rare to see such a huge company with such a tiny operating margin. If you ever wondered how Wal-Mart drives other retailers out of business, this is it. Wal-Mart has effectively used debt to leverage their returns and help compensate for having operating margins that other companies could not survive.
Wal-Mart understands how to use assets to create sales in a way that would make almost any company on earth jealous. Granted, having depreciated buildings helps reduce the value of assets, but Wal-Mart is posting exceptional numbers here. That has been a huge factor working for shareholders. Wal-Mart's effective use of their assets to generate sales has allowed them to avoid having "asset bloat". Assets require financing. Whether the company uses debt or equity, there is a cost to holding that capital. Wal-Mart has avoided holding onto things they don't need, which means the company is able to return the cash to shareholders instead of using it to finance unproductive assets.
The leverage ratios in the chart use the book value of debt and equity. That can be misleading because the book value of equity may be completely unrelated to the value of the company. I'll use the next two tables to provide more insight into the company's leverage. To clarify the calculation of the book value of equity, I'm only looking at the equity owned by Wal-Mart shareholders. Non-controlling interest is being excluded. Non-controlling interest directly reduces the net income available to shareholders in each period; therefore, I'm treating it as a liability. Not all liabilities are interest bearing, but any part of the company not financed with equity is in some way financed with debt.
Table 2 helps us look for potential changes in leverage. By seeing the value of cash, the book value of equity, and the shares outstanding, we can get a feel for how share buyback efforts are going and if we should anticipate a change in cash management.
So Equity has risen slightly, but the changes are not significant enough to be very meaningful. Cash has been managed with a steady hand and we haven't seen the company either hording it or lacking it. There has been a very clear trend down in the number of shares outstanding so we know the company's repurchasing activities are actually reducing the share count. Some companies promote their share buyback programs while giving more stock to executives through options than the company is buying back. Wal-Mart isn't one of those companies.
Table 3 provides more insight into the levels of leverage the company has been employing over the past few years. In this case we'll be using the market value for equity. Debt is still being defined as all things that are not shareholder's equity. That means I won't only look at long term debt when finding the company's level of debt. I want to include anything that will cost the company money.
So when we look at the company's values in debt by comparing them to the equity financing, we can see the company is actually financing about one third of their operations with debt. That's higher than normal for a massive company, but I think it is a wise move. As long as the company has operations to continue investing in, the choice makes sense. Paying off debts isn't bad, but at the current interest rates it makes sense to include debt financing in most structures. Wal-Mart's structure in particular has developed very steady operating margins, even though there are absurdly small, they are still very steady. Their lowest margin, 5.39%, was the margin for a quarter. For entire years, they are ranging from about 5.6% to 5.95%. Because those margins are so steady, the company has little reason to worry about handling their debt obligations.
Inventory is included in assets, but the DuPont Analysis doesn't' break out inventory as its own item. In this case, I think it is worth doing. I'll use Table 4 to compare the inventory turnover from the previous 3 complete fiscal years and the annualized versions for the most recent two quarters.
When I was browsing Wal-Mart's statements side by side I noticed that inventory was trending upwards at a significant rate. While Wal-Mart has continued to raise their sales from one year to the next, their inventory now represents a larger portion of sales. I think inventory turnover can be an awkward concept for some retail investors. So I'll break it down with an example. Across 2012, on average, the company carried enough products in inventory to meet sales for 31.47 days. Clearly, customers won't buy all products at the same rate, but in effect Wal-Mart's entire inventory would be turned over every 31.47 days. Across the first half of this year (combining Q1 and Q2) the company on average carried enough products in inventory for 35.1 days. Remember what we were saying earlier about asset bloat? Having more inventory on hand means more money that Wal-Mart has tied up. That inventory is either financed with debt or equity so it lowers returns to shareholders.
Wal-Mart has been fairly steady in their metrics over the last few years. From the perspective a defensive investor, consistency can be great. However, the company hasn't seen much price appreciation because the metrics aren't improving. In 2013, relative to 2012, the metrics were slightly weaker in the first four columns. That small decrease, in my opinion, explains the company underperforming the S&P Index. As an investor, the dividend yield has been a fairly safe source of capital. As long as the stock is being held with the intent of long term appreciation and gradual increases in the dividend, it serves a purpose. I am not expecting the company to grow as fast as the rest of the market, even with dividend reinvestment, and I'd consider myself slightly bearish on the stock. I believe the stock has dramatic exposure to any legislation that could raise wages for low skill workers and I believe the company has sustained their margins by reducing the quality of their products in recent years. I believe management has done a great job of utilizing debt to maximize value for shareholders, but I believe the company could find their metrics weakening in terms of inventory turnover and asset turnover as customers seek alternatives that offer better value than the traditional Wal-Mart stores. Sam's club, on the other hand, may provide some tailwind for the company as they are still offering values that are attractive to middle class customers.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.