While Wal-Mart (NYSE: WMT) has clearly been a megacap titan in the industry for quite some time now, garnering sales approaching half a trillion dollars in 2015, that's more or less the issue for investors. Where is the growth going to come from now? Or rather, how can shareholders best benefit from the dominant position Wal-Mart now finds itself in as its competitors in retail and wholesale continue to fade from existence? That's not an easy question to answer, because management has to balance the need to fuel growth and thus plow money back into operations, and return capital to shareholders to compensate for a lack of said growth, all while maintaining its stranglehold on the space it has come to dominate (alongside Amazon, and a few others). Sure, there's a hoard of cash to work with, but when you peel back the layers, you begin to see just how truly capital-intensive the business model actually is. Add the necessarily ambitious capital-return program and dividend scheme into the picture, and you can see that there is actually very little flexibility when it comes to realizing the Waltons' dreams of an unassailable corporate empire.
The Fundamental Aspect
As usual, I like to look at the top-line metrics before I dive too deeply into the income statement. From a revenue standpoint, the company is doing modestly well, considering the sheer size of the company. Growth is relatively steady, if not eye-catching. After all, WMT is a mature growth firm. At the beginning of the decade, in fiscal year 2007, Wal-Mart brought in $349 billion in sales, and by the end of the decade, in the most recent fiscal year reported, 2016, the company saw sales of $482 billion. That actually represents a compound annual growth rate in revenue of 3.28%. The chart below better illustrates the trend:
That is seemingly paltry growth, and in many respects, it is. However, Wal-Mart as an investment has become more akin to an income instrument like a bond, than it is a true equity play. With that in mind, it's important to see is that meager growth even sustainable, what's the trend, and what is management doing to enhance bottom-line returns for shareholders. Well, I have some mixed findings in my analysis, but I'm pretty sure I can get to the bottom of the matter.
While top-line growth is modest, it is nonetheless fairly steady in the 3+% range. Let's address the sustainability aspect now. The cost of that same revenue, or cost of generating sales (COGS), in quant parlance, is growing too, at a slightly lower rate of 3.18%. While it's nearly identical to the 3.28% revenue growth rate, it is obviously manageable, and shows that any growth in sales has the potential to be accretive to the bottom line, which is great news for shareholders holding onto WMT as one of the blue chip anchors to their portfolios.
So, revenue growth is nice and everything, albeit the modest amount we see in WMT, but what about the real bread-and-butter of what makes a stock worth owning: profits? Well, in that regard, WMT has again done admirably well, for its size. Gross profits, at least, have grown at a modestly respectable clip, going from $84 billion to $121 billion in 2007 and 2016, respectively. That represents an annual growth rate of 3.72%, slightly ahead of our revenue growth rate, which is a very good sign indeed.
Here's where things get a little dicey, however. So, gross profit has done fine over the last decade, at least with respect to the slow growth nature of the company and the capital intensive nature of the business. But what about costs? Wal-Mart, the king of cost-cutting for its customers, had better do the same with its own expenses, or any profit growth will be hard to maintain. Well, unfortunately, management's had a little bit of trouble keeping costs in line the way they'd probably like. For the same period, from fiscal year 2007 to 2016, Wal-Mart's total operating expenses grew from $64 billion to $97 billion.
That translates to an annual increase of 4.25%, slightly outpacing operating overall profit growth of 3.72% mentioned earlier. That is a sure sign of inefficiencies beginning to creep in, and is something that management is likely keeping a close eye on. Operating margins are compressing, albeit very slowly, but that is something executives will want to turn around before the sieve becomes a sink hole. Case in point: operating income has barely budged, from $20 billion in 2007 to $24 billion in 2016, or a growth rate of just 1.84%. Wal-Mart has seemingly hit a kind of earnings plateau, so to speak. So, how on earth are investors to benefit with such meager growth? Share-holder friendly policies, especially a strong capital return program in the form of dividends and buybacks.
Looking at the Earnings Picture
Let's face it, with such slow, near stagnant earnings growth, WMT has become something of a bond-like investment. There's nothing wrong with that, provided the risk is commensurate with the return. With that in mind, how has management returned capital to shareholders to help compensate them? Well, first and foremost, a massive share buyback program has been put into place, and reduced the overall number of outstanding fully diluted common shares from 4.17 billion in 2007 to 3.22 billion shares in 2016.
That means that management has bought back 22.7% of its total shares in the last decade. During that same period, diluted earnings per share have risen from $2.71 to $4.57, for an annual growth in EPS of 5.36%, far exceeding the growth in operating income of 1.84%. Now, I'm not averse to buybacks at all, in fact, I think they can be extremely accretive to individual shareholders, especially as they consolidate their own holdings relative to the market. But it's important to understand that growing earnings in such a way, is only as sustainable as is a company's ability to borrow cheaply. With interest rates beginning to rise, that leaves a somewhat grim prospect for Wal-Mart to be able to augment EPS growth in such a way going forward, at least not to the same degree as in the past 10 years.
Diluted EPS does not exactly paint a pretty picture either. Rather than exhibiting a steady trend line for growth over time, it's become clear that the bottom-line is far less stable than it once was, as the following chart clearly indicates:
Juxtaposed with the considerable decrease in overall share count, that development is even more worrisome, and points to some instability in the cost structure of the company, as of late.
To finish our analysis of the capital return efforts of the company, let's look at the last several years of dividends paid. In 2012, $1.59 per share was paid in dividends, in 2013 it was $1.88, 2014 it was $1.92, in 2015 it was $1.96, and in 2016, it was $2.00. That is a remarkable slowdown in per share dividend growth. In 2013 the dividend growth rate, year over year was a bit over 18%. In 2016, the growth rate had slowed to just 2%. The dividend growth slowdown may very well be the canary in the coalmine, telling investors that buybacks and dividends may have hit some sort of a wall. As interest rates continue to climb, it would be ill-advised to continue to rely on a robust capital return program to prop up shares.
After reviewing the facts, I think it's pretty clear that Wal-Mart's best days are well behind it. While that is hardly a news-worthy revelation, by any means, it does bear reassessing your position in the stock, if you currently have one. With the 2-3% growth rate in earnings, and slowing per share dividend and earnings growth, I'm not sure that the reward will be worth the risk for some time. While returns will likely reflect that of longer-dated corporate bonds. Personally, if you presently hold a position in WMT, I'd consider at least paring back my position, and if you are considering initiating a new position or adding to an existing one, I highly recommend waiting for a pullback of 20% or more in the share price. Currently trading at 15.5x forward earnings is far too rich for a company that has basically plateaued. Once that equity premium has fallen to more reasonable levels, to a P/E of say 11 or 12, then the risk-reward payoff makes sense.
*All charts and graphs courtesy of the author, Ben Black. Data used to construct the Excel graphs were exported from Morningstar.
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.