Wal-Mart: Buy On Strong Cash Flow

Apr.10.12 | About: Wal-Mart Stores, (WMT)

Wal-Mart (WMT) is the largest retailer in the United States, with discount stores that are known for low prices. As a mature chain, Wal-Mart has saturated most major markets throughout the U.S. Ongoing success for Wal-Mart depends on its ability to generate earnings growth from sales to new bargain hunters that are trading down.

Critics of Wal-Mart contend that low prices depress domestic wages and cause manufacturing jobs to be transferred overseas. This view has merit only if wages are set based on prices for commodities without regard to the output of labor. Buying preferences of the public are the optimal gauge of Wal-Mart's social value. The company's contribution to economic welfare with lower prices that expand consumption by low-income households is vastly underappreciated. If Wal-Mart continues generating a greater sales volume from higher income groups, the company should be able to hold its market position while leaving room for small rivals.

Therefore, maintaining relevance in the purchasing activity of the general public is the most important element in Wal-Mart's future. This article examines revenue growth at Wal-Mart, including same store sales and trends in profit margin. These measures are compared to both entrenched high tier retail operations and small competitors encroaching on Wal-Mart's low price merchandising theme.

Revenue Growth

Wal-Mart reported sales increases for its fourth quarter ending January 2012. The company encouraged consumer spending by holding down prices. This strategy was deployed so aggressively that profits declined by 2.9 percentage points. Quarterly net income slipped 13% compared to the same period of the prior year. However, Wal-Mart's CFO, Charles M. Holley, Jr., said that the drop was because of a net income number one year ago that included a non-recurring tax benefit from disposal of a German business unit. Holley conveyed that a more accurate figure to examine is income from continuing operations, which increased 3.4% for the quarter to $5.2 billion.

The pricing strategy at Wal-Mart depressed the gross margin on US sales by $100 million. Margins on fourth quarter sales for the entire company were lower by 40 basis points, dropping to 24.3%.

Sales grew 5.8 % in the fourth quarter compared to the same period last year. Of $122 billion in worldwide sales, the US portion made up $72.8 billion. This represented a 2.4% increase for stores in the US. Sales at stores open for at least one year were 1.5% higher in the fourth quarter, which marked Wal-Mart's second consecutive quarter of positive same-store sales. The company had previously experienced a slide in same-store sales for nine consecutive quarters.

Wal-Mart executives reported substantial customer use of the company's layaway program during the holiday sales season. However, layaway was not offered after the holidays, and January 2012 was the strongest month in the quarter for both sales volume and store traffic. Management also stated that consumers responded positively to the company's reintroduction of about 10,000 items to store shelves. These views are supported by evidence of increases in both number of store visits per customer and average spending per visit.

Although luxury retailers are not Wal-Mart's truest competition, the results at high-end stores are indicative of consumer buying patterns. In addition, changes in margins for merchandisers to the affluent buyers present a comparison to Wal-Mart's retail strategy. Below, I will look at Macy's (M), Saks (SKS) and Bloomingdale's.

According to Macy's chairman and chief executive, Terry J. Lundgren, consumers with higher incomes are purchasing more now than one year ago. But, he cautioned that some individuals are still impacted by economic challenges. Illustrating this dichotomy is the rise of 9% average per item prices at Macy's and Bloomingdale's. Lundgren reported higher sales of expensive items at Macy's - such as jewelry - as well as particularly strong luxury item sales at Bloomingdale's.

Macy's gross profit margin was 40.4% in 2011, and 41% in the fourth quarter. Profit margin for Macy's is higher than Wal-Mart. However, the margin decline of 30 basis points at Macy's from the same period one year earlier is similar to the profit margin fluctuation at Wal-Mart.

Saks Fifth Avenue released a statement that it was selling more high margin items, including jewelry, fragrances, and men's accessories. Gross margin in the fourth quarter of 2011 fell 20 basis points to 37.6%, compared to the previous year. But the company's full year 2011 profit margin increased to 40.8% from 40.1% in 2010.

The chief rivals of Wal-Mart are rapidly expanding discount retailers seeking to capture the expanding number of price-conscious consumers from all income levels. These chains have historically catered to individuals with modest incomes. They have small price markups on merchandise due to low overhead costs. Traditionally placed in rural communities, small towns, and suburban areas, discount competitors have much smaller store sizes. This enables location placement with neighborhood convenience.

The largest discount retailer by number of stores is Dollar General (DG), with over 9,600 locations in 35 states. Dollar General reported net sales increased 20.1% to $4.19 billion in the fourth quarter of 2011. Net sales increased 11.8% overall in 2011.

Same store sales increased 6.5% in the quarter, which the company attributed to higher customer traffic and a larger average transaction amount. Full year 2011 net sales at Dollar General increased 13.6%, and same store sales improved 6% for the year.

The company's gross margin in the fourth quarter of 2011 was 32.2%, a slight decline from 32.4% a year earlier. However, the cost of goods sold in 2011 included a larger charge than 2010 to increase the company's LIFO reserve. Selling, general and administrative expenses improved in the fourth quarter compared to the prior year, by declining 68 basis points.

The company's 2011 gross profit margin decreased 31 basis points from 2010 to 31.7% of sales. Management attributed this to rising relative sales of consumables, which generally have lower markups.

Discount retailer Dollar Tree (DLTR) reported results for the fourth quarter and fiscal year ended January 28, 2012. The chain sells everything in its stores for $1 or less. Net sales in the quarter increased 12.8% to $1.96 billion, compared to the same period one year earlier.

Same store sales increased 7.3% in the fourth quarter. Full year 2011 net sales at Dollar Tree increased 12.7%, and same-store sales increased 6% for the year.

The company's gross margin in the fourth quarter was 37.8%, an increase of 20 basis points from one year earlier. A drop of 30 basis points in Selling, General and Administrative expenses for the quarter contributed to the improvement of the company's net operating profit.

The company's 2011 gross profit margin was 35.9% of sales, an increase of 40 basis points from the previous year.

Family Dollar (FDO) is the fastest growing discount chain. The company added more than 4,000 stores in the past 10 years and now has nearly 7,000 locations in 44 states.

Family Dollar reported results for the second quarter of fiscal 2012 ended February 25, 2012. Net sales in the quarter increased 8.6% to $2.46 billion compared to the same period in the previous year.

Same store sales for the quarter increased 4.5%, which the company attributed to both higher customer traffic and a small increase in average transaction amount.

The quarterly gross profit margin slipped 80 basis points to 34.9%. The company's management says that gross margin was severely impacted by stronger sales of low margin consumables. However, the company is partially offsetting this trend by investing in private brands along the lines of Wal-Mart's "Great Value" brand.

Although Family Dollar has increased its advertising costs, the company benefited from a decline of 90 basis points in Selling, General and Administrative expenses for the fourth quarter.


Dollar General has a formidable market presence with over $4 billion in quarterly net sales. Family Dollar is on the rise with nearly $2.5 billion in quarterly net sales due to investment in new stores plus renovations, relocations, and expansions. While Dollar Tree sticks with its $1 or less pricing theme, it remains marginalized with quarterly net sales of less than $2 billion.

The strategy at both Dollar General and Family Dollar entails adding more consumables in order to increase store traffic. Along with this marketing technique comes the need to increase average store inventory. The food assortment attracts more individuals needing quick preparation items and ready-to-eat products for family meals between visits to a supermarket.

This strategic focus is important for the discounters to attract middle-income consumers, and thus offset reduced store traffic by lower income core customers still reeling from the weak economy. To capture more affluent bargain hunters, the discount stores must maintain consistent product offerings of regularly available items. This requires a merchandise mix accumulated by means other than closeouts and manufacturer overruns. That is one of the issues leading to declining margins.

Second, discount retailers are tremendously sensitive to macroeconomic factors because of their impact on cautious consumer spending. Competitive pricing and new products are vital for the discounters to attract shoppers, which compress margins further.

The quarterly decline of Wal-Mart's profit margin is no more severe than the drop of margins at competitors. Wal-Mart is better positioned for this because of its scale. With quarterly sales of $72.8 billion in the U.S. alone, Wal-Mart's 25% margin still generates considerable cash flow.

Moreover, the international operations of Wal-Mart will soon begin to contribute meaningfully to its profit margin. In addition, the company is seizing opportunities in underserved rural and small community markets with its Wal-Mart Express concept. An e-commerce initiative, while outside Wal-Mart's core competency, also has considerable promise if executed in a manner that complements store operations.

The most overlooked dynamic in favor of Wal-Mart is that even affluent consumers still love a bargain. This brings more sales of higher ticket items offered at Wal-Mart - even if the individuals with larger incomes still make their jewelry purchases at Macy's, Bloomingdale's, and Saks. Further benefiting Wal-Mart are the middle-income consumers who visit the company's stores for the wider selection. As Wal-Mart maintains its low prices, secondary choices such as Dollar General and Family Dollar become less attractive.

I expect Wal-Mart to maintain its market share and strong cash flow. The stock should be attractive to investors. Recognition of higher value will arise if the margins of small rivals continue to slip and Wal-Mart's margin stabilizes, or even improves, based on developments in foreign locations.

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