Wal-Mart's Boost From Lower Gas Prices Should Be Sold

| About: Walmart Inc. (WMT)
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Summary

WMT's earnings estimates are too high.

The boost from its customers' benefit from lower gas prices is likely transitory.

I think WMT is worth about $78 right now.

Shareholders of retailing giant Wal-Mart (NYSE:WMT) recently got the long awaited breakout from the channel the stock had been trading in for nearly two years. This breakout sent shares to new all-time highs above $87 on renewed optimism regarding consumer spending. With the breakout fizzling somewhat on the market wide pullback, is it time to add WMT to your portfolio? In this article I'll take a look at WMT and see if it may be a good defensive option in today's uncertain market.

To do this I'll use a DCF-type model you can read more about here. The model uses basic inputs including earnings estimates, which I've taken from Yahoo!, dividends, which I've set to grow at 9% per year, and a discount rate, which I've set at the 10 Year Treasury rate plus a risk premium of 6%.

 

2014

2015

2016

2017

2018

2019

2020

Earnings Forecast

             

Prior Year earnings per share

 

$5.11

$5.00

$5.24

$5.53

$5.85

$6.18

x(1+Forecasted earnings growth)

 

-2.20%

4.80%

5.67%

5.67%

5.67%

5.67%

=Forecasted earnings per share

 

$5.00

$5.24

$5.53

$5.85

$6.18

$6.53

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$23.59

$26.67

$29.81

$33.07

$36.43

$39.90

Earnings per share

 

$5.00

$5.24

$5.53

$5.85

$6.18

$6.53

-Dividends per share

 

$1.92

$2.09

$2.28

$2.49

$2.71

$2.95

=Equity book value at EOY

$23.59

$26.67

$29.81

$33.07

$36.43

$39.90

$43.47

               

Abnormal earnings

             

Equity book value at begin of year

 

$23.59

$26.67

$29.81

$33.07

$36.43

$39.90

x Equity cost of capital

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

=Normal earnings

 

$1.89

$2.13

$2.38

$2.65

$2.91

$3.19

               

Forecasted EPS

 

$5.00

$5.24

$5.53

$5.85

$6.18

$6.53

-Normal earnings

 

$1.89

$2.13

$2.38

$2.65

$2.91

$3.19

=Abnormal earnings

 

$3.11

$3.10

$3.15

$3.20

$3.27

$3.34

               

Valuation

             

Future abnormal earnings

 

$3.11

$3.10

$3.15

$3.20

$3.27

$3.34

x discount factor(0.08)

 

0.926

0.857

0.794

0.735

0.681

0.630

=Abnormal earnings disc to present

 

$2.88

$2.66

$2.50

$2.35

$2.22

$2.10

               

Abnormal earnings in year +6

           

$3.34

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$66.77

               

Estimated share price

             

Sum of discounted AE over horizon

 

$12.62

         

+PV of terminal year AE

 

$42.08

         

=PV of all AE

 

$54.69

         

+Current equity book value

 

$23.59

         

=Estimated current share price

 

$78.28

         

We can see the model produced a fair value of only $78, almost $5 lower than where shares trade as I write this. That would imply that WMT is moderately overvalued right now but before we move any further, we must understand what we're looking at. The model is intended to provide a price at which investors can get long and still achieve a margin of safety. Considering that WMT is already $5 above that price, the margin of safety is gone. But let's look a bit closer to see if WMT really is too expensive.

WMT has had a tough time in the past couple of years breaking out of a well defined channel. The channel formed as EPS growth was hard to come by and revenue growth the same; a retailer (or any company) the size of WMT is going to have a hard time growing revenue under most circumstances. However, with WMT, a company that targets lower income demographics and competes on price, consumer pessimism or inability to produce disposable income really hurts WMT's ability to grow. It is these consumers on the margin that see large fluctuations in their disposable income that WMT needs to grow.

With the recent slide in oil prices and with it, gasoline, WMT's consumers tend to benefit the most. Affluent consumers that probably don't give gasoline prices a second thought will of course have more disposable income with lower gas prices as well but aren't likely to increase their spending because of it. However, WMT's consumers that live paycheck to paycheck see a real boost in their disposable income when fuel prices decrease and WMT is the beneficiary of that. Thus, we've seen WMT shares increase on hopes that this newfound disposable income among consumers on the margin will allow WMT to pick up some much needed growth.

However, I think shares have been bid up a little too much. Unless WMT finds a way to seriously stoke growth I think it will have a hard time meeting analyst expectations of about 6% EPS growth per year. Revenue growth is coming in around 2% per year, margins are flat to down and buybacks vary but tend to retire less than 3% of the float each year. In other words, I don't see how WMT consistently produces 6% EPS growth. It's not like it's an outrageous number but I also think the estimates are very optimistic.

In light of this, the fact that WMT is already trading over my fair value price even assuming it does hit 6% EPS growth highlights for me that WMT is probably overvalued right now. The company is the preeminent retailer in the entire world and a model of efficiency that other business leaders have studied for decades, but that doesn't mean we can just pay anything to own it. Given the bleak prospects for growth for WMT I don't see justifying $83 right now.

We can see in this chart of WMT against the Dow 30 (NYSEARCA:DIA) that the channel WMT was trading in is pretty well defined against the rising market as well.

We can see the point at which WMT began its breakout referenced above as it began to greatly outperform the market after a period of consolidation against the Dow. Unfortunately, I think this period of outperformance may be short lived as I think it is due to lower fuel prices, a condition that is unlikely to persist for a long time. What we've seen is a nice short term pop based on a change in fundamentals that I don't think is long lasting.

Of course, that theory goes out the window if fuel prices sustain at low levels for a long time. WMT's customers really do benefit from lower fuel prices so the story works but what I'm saying is that for WMT to be justified at $83, you have to believe fuel prices will be low for at least a year. Otherwise, I'm not sure how you arrive at 7% or 8% EPS growth to justify the valuation. If fuel prices persist in a low range like they are now, WMT will ultimately benefit and we'll see shares higher. However, I'm not willing to make that bet.

WMT is a terrific retailer but right now, I think shares have been bid up due to a condition that I personally don't feel will last. I think the long term trend for fuel prices is still up and in that case, the reason for WMT's recent pop will evaporate. WMT will benefit in the short term but after the benefits dissipate, we're back to WMT trying to find ways to grow. I'd look at adding WMT under $80 but it's just too expensive right now. I put the fair value for WMT at $78 on low growth prospects. Of course, if fuel prices persist at low levels, I'd have to look at ratcheting that fair value up. But right now, I'm not interested at $83.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.