Wal-Mart: Q4 Was Likely Challenging

| About: Wal-Mart Stores, (WMT)

Summary

Negative traffic growth throughout last year has turned into positive traffic growth this year, but positive ticket growth has slowed/turned negative this year.

ASP degradation is causing margin compression, and we do not see this trend reversing in the foreseeable future despite fleet optimization initiatives from the company.

Pending revenue tailwinds, this could mean peak earnings are behind the company.

We believe the brick-and-mortar retail landscape was challenging this quarter for discount department stores, and are unsure of WMT's ability to top Q4 estimates.

Wal-Mart (NYSE:WMT) is expected to announce 4Q16 earnings on Thursday, 2/18. We do not believe it was a strong quarter for the discount department store chain, and further believe the current valuation implies shares have more room to fall in the near term.

As a low-cost department store with a price-preferred target customer, WMT is the principal victim of pricing pressure from Amazon (NASDAQ:AMZN). We pointed out following 2Q15 results that increased traffic was being driven by steep discounting, and this high cost of customer acquisition traffic was driving margins down.

This trend magnified in 3Q15. The 1.5% domestic comp in Q3 was driven by a 1.7% increase in traffic, but that was accompanied by a 0.2% drop in average ticket. The positive comp drove a 3.8% increase in sales, but strong sales growth didn't follow through to the profit line. Operating income fell 8.6% in the US.

We think this divergence in sales and operating income growth is mainly attributable to pricing pressure from AMZN. Negative traffic growth throughout last year has turned into positive traffic growth this year, but positive ticket growth has slowed/turned negative this year. While WMT has solved its traffic problems, it's doing so in a margin-compression fashion.

WMT is optimizing its fleet, closing low-performance stores in US, Brazil, and elsewhere in Latin America while opening more supercenters and Neighborhood Markets in the US and expanding strategically in international markets. These moves will hopefully help margins, as well as alleviate some opex through labor force reduction. Opex alleviation through labor force reduction, though, will likely be washed with increased labor costs from pay raises to over 1 million employees (part of a two-year, $2.7 billion investment in workers).

In the coming years, we will see fleet optimization tailwinds combat ASP degradation headwinds, and we believe ultimately that pressure from a low-cost e-commerce competition like AMZN will weigh on margins more than fleet optimization will help margins. We expect to see continued margin degradation over the next several years.

Pending revenue tailwinds, this could mean peak earnings are behind the company. At ~14x trailing earnings, the current valuation is not fully baked with this concern. If the company misses estimates this quarter, we think shares still have more room to fall.

We believe multiple signs point to a weak quarter for WMT. A blizzard likely took a small hit on sales. Weak Kohl's (NYSE:KSS) results have weighed on the entire retail sector, and we believe KSS's results are a good gauge of WMT's results in this retail landscape. Both are low-cost department stores with a price-preferred target consumer. AMZN reported strong North American retail revenue growth, and this gives us pause on WMT's holiday results, especially considering SimilarWeb is reporting that Walmart.com traffic has been relatively weak in December and January.

Overall, we are not confident that WMT can top estimates this quarter. With ASP degradation headwinds compressing margins in the foreseeable future, we believe the valuation isn't terribly attractive. Overall, we will remain on the sidelines with WMT for now, but believe shares have considerable downside if the company misses estimates on Thursday.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.