Wal-Mart's Strong Q1 Suggests It's Still Underrated

| About: Wal-Mart Stores, (WMT)

Summary

Setting aside the impact of planned wage investments, Wal-Mart's Q1 looked pretty good.

Comps were up, gross margins improved and while e-commerce growth wasn't as strong as it could have been, the company's efforts are still in the right direction.

Wal-Mart's "problems" are all self-inflicted and I don't see any reason why its valuation multiple should be so far below peers like McDonald's and Procter & Gamble.

Wal-Mart isn't a stock to own if you're expecting big returns, but I do think relative valuation suggests shares should trade in the low $70s.

Wal-Mart (NYSE:WMT) is the sort of company I follow not so much as an investment prospect, but rather to keep track of big-picture trends in food, retail, e-commerce and the general health of the consumer. Relative to other companies I follow in the same vein - such as Procter and Gamble (NYSE:PG) and McDonald's (NYSE:MCD) - I continue to think that Wal-Mart is relatively underrated.

Controllables Controlled In Q1

Fiscal '17 (calendar '16) was never going to be a particularly spectacular year from an earnings standpoint, as significant investments in wages were projected to hit earnings by 6-12% relative to 2016. Due to timing, Q1 was expected to be the hardest-hit - but Wal-Mart outperformed, with guidance coming in at $0.98, higher than the range of $0.80-$0.95.

Across most metrics, Wal-Mart executed well in Q1. U.S. stores delivered +1% comps, with good traffic (up 1.5%) offset a little by food deflation. Gross margin also improved by 44 basis points, while inventory declined by 3.5% (5.7% on a comparable-store basis). Finally, while e-commerce growth (7%) isn't going to blow anyone away, I continue to be pretty impressed by the moves Wal-Mart is making in this area. The ubiquity of Wal-Mart's stores (and the strength of its supply chain) is a good starting point to leverage e-commerce in ways that few others can - online grocery pickup, in particular, appears to be gaining traction with consumers.

The Valuation Argument Is Relative

If you're looking for blockbuster returns, look elsewhere; Wal-Mart is obviously not the sort of company you buy hoping for a short-term double. At the same time, within the context of defensive, dividend-paying companies, I continue to believe Wal-Mart isn't getting its full due.

Earlier this year, I argued that in light of the 20x+ P/E multiples that companies like McDonald's and Procter & Gamble traded at, Wal-Mart should merit at least a high-teens multiple, which would put the shares in the low $70s. That argument continues to hold - neither P&G nor Mickey D's past few quarters have given me any reason to believe they're better positioned over the medium to long term than Wal-Mart is.

In fact, I think that Wal-Mart is better positioned in many ways. Unlike P&G or McDonald's, its "problems" are more self-inflicted than external. P&G's brand power has deteriorated and McDonald's poor taste and nutrition don't mesh with where the world is going; while Wal-Mart certainly faces threats from e-commerce, it doesn't face these to the same degree as most retailers and could actually be a beneficiary.

In the near term, the earnings decline is really a matter of Wal-Mart biting the bullet and making a big investment in wages. They could have chosen to delay this, but doing it before they had to not only earns them PR points, but may lead to greater productivity and a better guest experience. This move, incidentally, is something I believe McDonald's may eventually have to mirror - and it's not being priced into those shares.

Relative to McDonald's, Wal-Mart also has a clean balance sheet should it decide to more actively or aggressively return capital to shareholders.

Admittedly, a relative valuation argument like this isn't my favorite to use - and as a returns-focused investor, there's no real reason for me to own a mega-cap like Wal-Mart when I have plenty of small-cap opportunities - but for investors looking for a combination of current income and modest growth in a well-entrenched household name, Wal-Mart seems much more appealing than other options.

Final Thoughts

Wal-Mart continues to demonstrate why it has the reputation that it has in the business world: Setting aside the planned and intentional impact of the significant wage investment, business results look pretty good and the company doesn't appear to face the same near-term challenges (nor long-term business model questions) that many of its peers do. Although I don't personally see a compelling reason to own any giant company with valuations where they are, Wal-Mart's continued strong results and undemanding valuation seem to make it one of the better picks.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Discount, Variety Stores, Earnings
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