Wal-Mart: Overpriced At $67

Jun.14.12 | About: Wal-Mart Stores, (WMT)

Wal-Mart (NYSE:WMT) bas been sued by an investor in the US District Court in Tennessee for alleged violations of Federal securities laws in connection with a large bribery scheme at its largest subsidiary Wal-Mart de Mexico and a six-year effort to cover up the scheme by top managers and directors.

The complaint alleges that between December 2011 and April 2012, the company made false and misleading statements about an alleged bribery scheme in Mexico and caused the stock to trade at artificially inflated prices. On Sunday, April 22, 2012, the New York Times carried a detailed article concerning bribes at Wal-Mart de Mexico beginning in 2005 which may have totaled more than $24 million. The article also stated that there is reason to believe that there could be violations of both US and Mexican law. The company has responded by stating that it has met with federal authorities and made a self disclosure of its ongoing investigation. Stock prices dropped and wiped out billions of dollars in market capitalisation.

However, any coverage of the bribery scandal took a back seat after the release of its latest quarterly results. Much to the surprise of many analysts, net income took a big jump off almost 10% to $3.74 billion (earnings per share of $1.09 per share) against the $3.4 billion and $.97 per share recorded in the same quarter of the previous year. The consensus estimate was $1.04 per share. Because of the ongoing Mexican bribery scandal, the company claims that it was difficult to concentrate on international expansion and that during the quarter, much of the focus was on business in the US and the promise of everyday low prices. The lower prices resulted in more traffic and sales and generated an increase of nearly 6% in its stores in the US. Overall revenue for the company rose by over 8% to $113 billion.

The business model that Wal-Mart follows is based on its strategy of everyday low prices. With the problems in the economy of the last few years, consumers have become focused on pricing to ensure that they get the maximum value for their money. Wal-Mart has been able to implement its low-price strategy by focusing on managing its costs and passing on cost savings to the customer. As a result, it has become the largest retailer in the world with revenues in excess of $440 billion. It uses its size and purchasing power to obtain the lowest possible prices from suppliers but, in turn, suppliers are assured of large volumes. These savings in procurement costs are then passed on to customers. The company is also able to influence its suppliers to implement cost reduction strategies in areas such as product development and packaging. The retail industry has become fiercely competitive rock bottom margins and competitors such as Target (NYSE:TGT) have been forced to implement extensive customer loyalty programmes in order to keep the footfalls coming.

Wal-Mart has over 10,000 stores all over the world selling goods across many categories of merchandise such as groceries, electronics, appliances and clothing. It operates in three major business segments namely Walmart U.S., Walmart International and Sam's Club and Wal-Mart US accounts for around 60% of its total revenues. However, Wal-Mart is struggling to establish an online business and Amazon (NASDAQ:AMZN), for instance, draws almost twice as many visitors and sells more than three times as much online. Other competitors such as Target and Costco (NASDAQ:COST) are pushing to level the online playing field. Apart from online competition, customers strapped for cash have also turned the dollar stores in a big way and the largest Dollar General Corporation (NYSE:DG) has done very well for itself. Wal-Mart is hitting back at the dollar stores with a smaller stores format called 'Wal-Mart Express' which is around 15,000 ft.² in size compared to an average of 185,000 ft.² for its Supercenters.

Because of its aggressive pricing policies, Wal-Mart has to operate in a highly defensive manner. The everyday low prices strategy is itself somewhat of a constraint on any dramatic sales growth. For the economies of procurement, the company outsources inventory and procurement to China and the weakness of the dollar against the yuan must be a considerable concern. The weakness of the dollar generally could prove to be a limiting factor when it comes to sales growth.

Compared to the predicted sales growth of around 8% for the second quarter for Wal-Mart, its peers are generally expecting to do better. Costco is expected to grow at around 14%, Dollar General is expected to grow at 18%, and PriceSmart (NASDAQ:PSMT) is projected to grow at 43%. Only Target is expecting negative growth with a decline of over 7%. Moreover, Wal-Mart is expected to add about 30 million ft.² of additional retail space in the current financial year but it remains to be seen what penetration in countries like Ethiopia and Pakistan will add to the top line. India which is one of the most promising markets in developing countries continues to restrict foreign investment in the retail trade. We will also need to see what impact the Mexican bribery scandal as on the international expansion of the company generally.

Wal-Mart is a reasonable buy. The dividend yield of more than 2% is likely sustainable for the foreseeable future. However, I do not believe there is much potential for capital appreciation, as the stock seems overpriced at around $67. I recommend holding onto this stock, and buying on dips to the low $60 range.

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