Walmart: Bye Bye Brazil

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About: Walmart Inc. (WMT)
by: The Value Investor
Summary

Walmart is exiting Brazil to a great extent.

The deal does not come as a major surprise as Walmart has been pulling back from troubled international operations, although it recently made a big move into India of course.

I understand the divestments but do recognise that leverage is generally on the increase as competition remains fierce, despite a recent improvement in operating performance.

Walmart (WMT) has attracted my interest after the business has seen a solid turnaround in recent years, even as I had some doubts about the recent Flipkart deal and the (partial) exit in the UK, as the company is now exiting the Brazilian market as well, in a deal which seems to be close to "selling at the bottom".

Nonetheless, the deal is probably for the best in the long-term interest of shareholders, as the impact in terms of sales, let alone earnings, is not meaningful, or even positive (as the company is losing money in Brazil). Of course, Walmart has enjoyed some recent operating momentum although at the expense of margins, as I wait for further dips before jumping aboard.

Advent To The Rescue?

After I have been growing more upbeat on Walmart, given the recent improvements in the operating performance, in combination with a recent pullback in the stock, I was somewhat surprised to learn that the company is largely exiting the Brazilian market. While the company has seen struggles, Brazil should remain a long-term growth market, although that potential is often overshadowed by (political) challenges.

Private equity fund Advent, active in Brazil for two decades, has reached an agreement to acquire 80% of Walmart Brazil, as the company itself will retain the remainder 20% of the shares.

No price has been mentioned, yet the price is probably disappointing as Walmart is recording a non-cash charge of $4.5 billion in relation to the deal, mostly the result of cumulative foreign currency translation losses. That said, the business is losing money as Walmart anticipates a slight positive impact to next year's earnings. In either case, the impact is rather modest as Walmart Brazil generates sales of 25 billion real, equivalent to roughly $6.5 billion in dollar terms at current exchange rates.

That implies that a sale of the entire business has a pro forma impact of 1.3% on total sales, as the 80% stake in the Brazilian operation reduces revenues by about a percent. Having little impact on sales, the deal is an admittance that Walmart has been unable to make any money despite the promise of the country, facing too much competition from Carrefour (OTCPK:CRERF) and Casino as well as political challenges.

This deal follows the disappointments in the UK, as expansion in other (European) countries has not been a great success either, while the company spent a huge sum recently to expand into India. The only "smart" thing in the global exit strategy which includes the UK, China, and now Brazil, is that Walmart is often retaining a (small) interest in the "divested" business, while partnering up, or investing in a local partner. If this partner succeeds in turning around the business, at least Walmart and its shareholders stand to receive part of the benefits.

Reiterating The May Thesis

While I never advocate selling on the low, exiting Brazil was long overdue for Walmart as a simpler global business is needed to focus on operations where the company can grow sales and be structurally profitable, while all attention and resources are needed to fight the fight with Amazon.com.

Yet this strategy bears risks as well after the company spent $16 billion in May for a 77% stake in Flipkart, buying the majority stake at a $21 billion valuation (for the entire company) at the time. That is a big prize for a company with revenues of $4.6 billion, as revenues are even less than the Brazilian operations, while the gap in the valuation is huge of course. The only good news is that the (largely) exit from Brazil will stop the losses of that business (attributable to Walmart) to a large degree. This is important as Walmart will incur quite some additional interest costs following the Flipkart deal, as well as the assumption of its operating losses.

Narrowing the losses is important as Walmart has seen pressure on its margins for quite a while now, while net debt will jump to $56 billion on a pro forma basis following the Flipkart deal, equivalent to about 1.8 times EBITDA. Not incorporated in this number is the deal in the UK and the unknown proceeds for the assets in Brazil.

Quick Review Of First Quarter Results

A week after the announced purchase of the majority stake in Flipkart, Walmart reported reassuring first quarter results, as revenues were up by 2.7% if we strip out the contribution from currency moves, which has been positive, given the dollar weakness over the past year. Walmart US comps were up by 2.1% on the back of a 0.8% increase in comparable traffic, as notably Sam's Club reported very strong growth numbers, especially in terms of its traffic.

Reported earnings fell to $0.72 per share, but that it unfair as it includes mark-to-market losses on the stake held in JD.com (NASDAQ:JD), after its shares were down this quarter. The adjusted earnings number of $1.14 per share seems fair, up from $1.00 in the first quarter a year ago.

Other than that, the first quarter results did not contain many large surprises, besides the relentless focus on the eCommerce operations. Walmart US eCommerce sales were up 33% and contributed 100 basis points to reported sales of $77.7 billion in the first quarter. That suggests that the 33% growth is equivalent to roughly $770 million in additional sales this quarter, for eCommerce sales of $3 billion this quarter.

That in itself suggests that US eCommerce sales run at about $12 billion. If we add in some overseas eCommerce revenues, as well as eCommerce revenues at Sam's Club and the purchase of Flipkart, it seems safe to say that eCommerce exceeds $20 billion going forward, which creates a giant company on a stand-alone basis, yet is equivalent to just 4% of total sales.

Buying Further Dips

In May, I concluded that appeal was luring as shares fell from levels just above the $100 mark to levels in the low eighties at the time, trading at $82 to be more precise. With earnings power seen at $4.75-5.00 per share, multiples had contracted to roughly 17 times, more or less in line with the market, although the multiple jumped by about 1 times after factoring in the expected dilution from Flipkart.

So trading at a market multiple, I did see relative appeal given the operating momentum, yet noted that Walmart has long-term challenges at hand, as expensive deals made that traditional very conservative leverage was on the increase as well. I furthermore note that momentum for Walmart during 2017 has been very strong, as investors should recognise that, despite a 20% pullback from the recent highs, shares are still up meaningfully on a 12-month basis.

Shares have recently recovered to $85, following the in line first quarter results, as neither the first quarter results nor news from Brazil make that I am re-considering the buy orders waiting around the $80 mark.

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.