By The Valuentum Team
Wal-Mart's Investment Considerations
• Wal-Mart (NYSE:WMT) operates retail stores. Its Wal-Mart US segment includes the company's mass merchant concept in the US. Its Wal-Mart International segment consists of the company's operations outside of the US. The Sam's Club segment includes warehouse membership clubs and samsclub.com. Social pressures will keep the retail giant in the news, and sometimes not in the best of light.
• Though Wal-Mart faces pressure from both Amazon (NASDAQ:AMZN) and discount dollar stores, consumers continue to flock to its locations. Its everyday-low-prices strategy has revolutionized the industry. Wal-Mart has staying power. The firm is laser-focused on improving margins via re-engineering processes to reduce costs and creating a more efficient box for new stores. Yearly price increases to the tune of 2%-3% should be expected. EPS is targeted to advance 7%-8% on an annual basis.
• Wal-Mart International is the company's primary growth engine. With $125 billion in sales, its international business alone would be among the three largest retailers in the world. The company remains focused on expansion in Brazil and China. A spin-off of Sam's Club would be a huge catalyst for shares.
• From what we can gather, Walmart is at the center of a political upheaval in America that is challenging its business model. The company has become the poster child for all of what many workers believe is unfair pay, and such a tainted perception, fair or not, will be difficult to overcome as the ranks of millennials swell and demand their definition of "a living wage" after suffering through a very painful Great Recession. We talked about the upward path of labor expenses before, and we don't see a scenario where they will abate…at least not anytime soon.
• Taking a page out of Costco's (NASDAQ:COST) playbook, Walmart is increasing its minimum employee wages in an effort to reduce training costs. We think the move will eventually bear fruit, as it incidentally increases entry barriers. Cost pressures will hurt in the near term, however. Currency headwinds also can't be ignored.
• We want to be able to tell you that everything will be "okay" at Walmart, that it will improve the customer experience, that it will revitalize employee relations, that it will overcome changing consumer behavior and e-commerce proliferation at Amazon, eBay (NASDAQ:EBAY), other e-commerce websites. But we don't think it will, at least not anytime soon. We also wish we could tell you that shares of Walmart are cheap now that they have fallen from ~$90 per share in early 2015 to under $70 today. But they're not. Fundamental challenges have become structural ones with new wage legislation across the US, and we expect shares to continue to face pressure.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Wal-Mart's 3-year historical return on invested capital (without goodwill) is 16.6%, which is above the estimate of its cost of capital of 8.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Wal-Mart's free cash flow margin has averaged about 2.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Wal-Mart, cash flow from operations increased about 11% from levels registered two years ago, while capital expenditures fell about 6% over the same time period.
In its first nine months of fiscal 2015, Wal-Mart reported net cash provided by operating activities of ~$15 billion and capital expenditures of ~$8.2 billion, resulting in free cash flow of ~$6.8 billion, a fall of ~6% from the same period of 2014.
This is the most important portion of our analysis. Let's quantify all of the qualtiative information we've been talking about. Below we outline our valuation assumptions and derive a fair value estimate.
Our discounted cash flow model indicates that Wal-Mart is worth $61 per share with a fair value range of $49.00 - $73.00. Shares are currently trading at ~$63, in the upper half of our fair value range. This indicates that we feel there is slightly more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our model reflects a compound annual revenue growth rate of 2.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 2.8%. Our model reflects a 5-year projected average operating margin of 4.9%, which is below Wal-Mart's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. For Wal-Mart, we use a 8.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $61 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Wal-Mart. We think the firm is attractive below $49 per share (the green line), but quite expensive above $73 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Wal-Mart's fair value at this point in time to be about $61 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Wal-Mart's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $74 per share in Year 3 represents our existing fair value per share of $61 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Wal-Mart continues to be a powerhouse in its respective industry, and we don't see it going away anytime soon. Recent initiatives to raise employee wages in an effort to reduce training costs could prove to be beneficial, but cost pressures may hurt in the near term. Wal-Mart boasts a healthy dividend track record, but its Dividend Cushion ratio is near parity, indicating that dividend growth may be subdued in coming periods.
All things considered, we are not rushing to pick up shares of Wal-Mart. We see little valuation opportunity in shares at the moment and are comfortable staying on the sidelines. Social troubles could prove too much to right the trajectory of its operations, and to a large degree, such obstacles remain difficult to predict. The firm currently registers a 6 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.