Wal-Mart Investors Jumping the Gun

Heading into this past Thursday, Wal-Mart (WMT) had forecasted a 2% increase in same store sales, with Wall-Street expecting 0.8%. The company sailed past both estimates, recording a 2.4% increase in sales. Wall Street reacted by sending the stock up for the day, with the general consensus being that the 2.4% increase in same store sales represented a strong month for Wal-Mart and that perhaps, maybe Wal-Mart was back. I’m of the opinion (however), that Wal-Mart’s sales results for June weren’t as strong as most investors think for the following reasons:

1) Margin Squeezing Discounts: Wal-Mart admitted to using deep discounts to drive sales, as a result the impact of June’s revenue on earnings will be less than many think. Generally speaking, it’s not a good sign when you have to put negative pressure on profit margins to beat a lowered sales estimate. The more important data point, is earnings for the last quarter when you include June’s revenue and May’s weak (1.1% increase, when you exclude gas) same stores sales performance.

2) Unsold Inventory Concerns: Back in May, a report in the Wall Street Journal noted that unsold inventory of clothing and household items had jumped by 10.3% in the fiscal first quarter on a YoY basis to a total of $35.2B, with $2B of that total being apparel and households goods. That same report quoted WMT’s CFO as saying that “working off excess inventory was going to depress margins for most of the summer. Based on the inventory data several analysts estimated an impact on earnings in the area of $0.05/shr. For the month of June, Wal-Mart reported that clothing and household item sales were weak. This seems to indicate that it may take a bit longer than the rest of the summer to liquidate their excess inventories, particularly when you consider the deep discounts aren’t working.

3) Grocery Sales: Wal-Mart’s noted that sales of groceries appeared strong during the month of June, continuing a four month trend of groceries outpacing general merchandise sales (with the exception of electronics). When viewed alongside the overall 0.9% YoY drop in retail sales, it appears that Wal-Mart is attracting up-market customers in search of cheaper groceries. The concern here (for me), is that it doesn’t appear these customers bought other items, just groceries, which seems to indicate that Wal-Mart will lose these customers when the economy picks up again; and/or when food prices start to decline as the prices for many items has been inflated as of late. Finally, as Barry Ritholtz noted, increased prices for food inflated June’s revenue numbers, this (again), is part of a pattern of more revenue than earnings.

However, the above doesn’t mean that June was all negative for Wal-Mart:

1) Electronics was a strong point, led by LCD televisions and the new line of Dell (DELL) computers . However, as I pointed out on my piece on Best Buy, Wal-Mart has consumer electronics competitors that are better able to monetize electronics sales. It will be interesting to see how this plays out long-term, as I can envision a scenario where Wal-Mart does significant volume via deep discounts, but lower volume competitors actually generate more profits, particularly on a per unit basis.

2) Their announcement around creating money centers that will provide check cashing, money orders, money transfers and other financial services typically provided by check cashing places is an excellent move. Wal-Mart will benefit via having a new source of earnings growth and the increased disposable income of its customers (Who will have more net income due to paying less in check cashing fees).

Overall, I think investors got a little ahead of themselves last Thursday, as they took the revenue number on its face value, without considering the negative margin pressures. When looking at retail stocks, it’s important to consider how revenue was generated, as opposed to always just looking at raw revenue growth as not all sales are created equal. The true test of how well Wal-Mart did during the month of June (and over the past quarter) will be when the quarterly earnings report comes out.

On a long term basis, I think investors need to pay more attention to earnings growth (instead of same store sales), as Wal-Mart’s business model can inflate revenue to the detriment of earnings. They should also look at how well Wal-Mart executes with respect to focusing on and serving their core customer. Wal-Mart focusing on initiatives like the Money Centers, as opposed to selling more “fashion” items, is the key to driving future earnings growth.

WMT 1-yr chart

Disclosure: none

Comments

[Long-ShortGuy]

Doesn't look like things are going well on the apparel front:
<blockquote>
<b>Wal-Mart shakes up executive ranks</b>

Wal-Mart Stores has announced the resignation its apparel chief, Claire Watts, after the company failed to increase clothing sales.

A company spokeswoman, Sarah Clark, on Friday, declined to say why Watts had resigned. A person answering the phone at Watts's office said she was unavailable for comment.

Watts's departure comes after Wal-Mart, the world's largest retailer, retreated from attempts to lure shoppers with more fashionable clothing, including its Metro 7 line of dresses.

Same-store sales at U.S. stores last year increased at their slowest pace since at least 1980...
</blockquote>

Source:
iht.com/articles/2007/...