Since 2002, investors have been bidding down the multiple they are willing to pay for the world's largest retailer, Wal-Mart (WMT). The price-to-earnings multiple has averaged about 18.8x over the past 10 years and has trended steadily downward from a peak of about 29x on average in 2002 to about 13x on average in 2011. At a recent price of about $59 per share, Wal-Mart currently trades at a price-to-earnings multiple of about 13.1x or more than 50% less than the average in 2002. In addition to this severe reduction of the earnings multiple, since 2006 the shares have been trading at a discount to the broader market, which is a reversal from the premium that the shares commanded from 2002 through 2005. In 2002, Wal-Mart shares' average price-to-earnings multiple of about 29x was about 1.5x the S&P 500 multiple of about 20x. In 2009, this ratio reached its low point at about 0.85x on average and has since recovered to about 0.98x on average for 2011 when Wal-Mart had an average price-to-earnings multiple of about 13.4x compared with the S&P 500 multiple at about 13.7x. The company's growth rate in earnings per share has slowed to about 1.1% in 2011 from about 21.5% in 2003, which yields a price to earnings to growth ratio, which has increased from about 1.3x in 2003 to more than 13x in 2011. While certainly discouraging for current holders of the stock over the past decade, this shrinking valuation presents potential investors with an opportunity based on the company's solid fundamentals and potential for improved profit and cash flow growth going forward.
Although Wal-Mart has seen its earnings multiple shrink due to declining revenue and earnings per share growth over the past decade, the company has been able to maintain its cash flow generating capability. Over the past 10 years, the company has produced operating cash flow on average of about 5.6% of revenue with a tight range of about 5.1% to 6.4%. During the same time span, free cash flow has averaged about 1.9% of revenue, ranging from a low of about 0.7% and a high of about 3.4%. In terms of cash flow growth over the past decade, Wal-Mart has increased cash flow from operations by about 9.0% annually while free cash flow has grown by about 19.1% annually. This growth in cash flow is a reflection of the company's ability to improve efficiency as it has increased its return on equity to about 25% in 2011 from about 20% in 2002 and an average over the past decade of about 21.2%. Likewise, return on invested capital has been improved by the company to about 13.3% in 2011, from about 12.1% in 2002, and an average over the past decade of about 12.9%.
The company is pursuing three initiatives that should be the basis for revitalizing profit and cash flow growth, which in turn augers well for price-to-earnings multiple expansion both in absolute terms and relative to the S&P 500. First, Wal-Mart is entering the e-commerce area, which is expected to give the company better returns on investment than traditional bricks and mortar stores. Next, the company is gaining critical mass in its international segment, which is expected to contribute meaningful profit margin expansion and return on invested capital. Finally, the company has an opportunity to capture more domestic market share through its Wal-Mart Express format, which targets underpenetrated urban and small rural markets. These initiatives come with risks that could derail the potential payoff and include: the e-commerce sales could be poorly executed as it is outside the company's core competency and could cannibalize sales at traditional outlets; international efforts have been ongoing for about a decade in some markets and have yet to match expectations indicating the company's inability to compete effectively; and Wal-Mart's dominance in the U.S. up to about 2002 was primarily against "mom and pop" retailers but the company is now facing much larger and aggressive chain grocery stores such as Costco (COST) and deep discount dollar stores such as Dollar General (DG) and Dollar Tree (DLTR). Costco announced a 10% increase in revenue and a 7% increase in same-store sales for the most recent quarter ended February 2012. Dollar General announced an 11.5% increase in revenue and a 6.3% increase in same store sales for the most recent quarter ended October 28, 2011. Dollar Tree announced a 12.8% increase in revenue and a 7.3% increase in same-store sales for the most recent quarter ended January, 28, 2012. These gains compare with Wal-Mart, which reported a 5.8% increase in revenue and a 2.4% increase in same-store sales, which suggests that Wal-Mart is losing market share. In order to counteract this trend and regain market share, Wal-Mart will need to reduce its profit margins. This is a viable strategy because Wal-Mart has some of the highest margins in the industry.
The trend in retail in recent years has been toward the poles of ultra luxury brands and extreme discounters with the middle of the retail market being squeezed. The "Consumer Hourglass Theory" suggests that the affluent consumer segment continues its spending on high-end products, while middle income consumers are trading down to deep discounting retailers such as dollar stores. This trend leaves Wal-Mart and Costco somewhat out of the mix as they serve a more middle market consumer. For example, Dollar Tree has avoided the series of same-store sales declines that Wal-Mart went through while luxury brands such as Coach (COH) have seen their shares soar recently to 52-week highs.
Fair value for Wal-Mart is right at its recent price of about $59 per share based an analysis of discounted free cash flows. This model assumes growth in free cash flows of 10%, which is below the historical annual growth rate of about 19%. This conservative assumption is made because analysts' forecasts for the next two years call for revenue and earnings growth below historical averages, which will negatively impact free cash flow growth as well. Wal-Mart has been able to achieve the 19% free cash flow growth rate by growing earnings per share by about 11.7% and revenue by about 7.4% annually since 2002. However, analysts are estimating earnings per share to grow by only about 8.2% in 2012 and by about 8.8% in 2013 while revenue is forecast to increase by only about 5.5% in 2012 and by about 4.5% in 2013. I agree with these estimates given the still cloudy global economic picture and the risks specific to Wal-Mart such as execution risk related to its e-commerce strategy, difficulty in realizing goals in its international segment, and untested "Wal-Mart Express" format in the U.S. Wal-Mart shares are a good buy if the shares fall with a broad market sell-off to a level closer to $50 per share or when improving profitability and earnings per share growth rates provide evidence that the strategic initiatives are working. When that occurs, owners of Wal-Mart should expect to see shares rise more than the broader market due to the double whammy of higher earnings and an expansion of the price-to-earnings multiple.