Attention Wal-Mart Shareholders: Another 10% Discount on Our Stock

Wal-Mart surprised the market with 3QF16 earnings per share of $1.03, excluding a one-time lease benefit of $0.04, still beating the street’s estimate of $0.98.  The short-term drivers included the comps up 1.5% from a 1.7% increase in traffic, after offset by a 20 bps decrease in transaction value by food deflation. Margin expanded an unexpected yet impressive 60 bps from a price deflation in grocery, general merchandise and consumables, citing significantly lower gas and diesel cost.  Another bright spot is that the smaller format Neighborhood Markets comps were up by 8% and consistently positive for the last 19 quarters.

Like everyone else, Wal-Mart experienced significant currency headwinds, evident by the 3.2% increase in net sales on a constant currency basis, versus -11.4% on a reported currency.  Operating income also decreased 6.4%.  The unfavorable FX exposure allowed only 7 of the 11 international markets to produce positive comps for the past 6 quarters. Higher wages, from $9 to $10 an hour, increased their investment in labor and training cost by $1.2 billion in FY15. It was considered the main driver for the sequential earnings decrease.  On the other hand, this is also the reason why in-store shopper experience has improved in the recent quarters, leading the comps to increase.

Wal-Mart plans to close 269 locations out of over 11,600 worldwide stores (less than 1% of square footage and revenue).  Out of the 269, 154 locations are in the U.S., including 102 Wal-Mart Express (smallest format stores in pilot since 2011), and 115 outside of the U.S.  More importantly, the company’s traditional stores will not see material closures.  In fiscal 2017, Wal-Mart plans on opening 50-60 Supercenters and 85-95 Neighborhood Markets (mainly grocers). Internationally, the company plans on opening 200-240 stores. On the other hand, in 3QF16, there were 15 supercenters and 35 Neighborhood Markets open.

All in all, we don’t think that store opening/closings pose a material impact on Wal-Mart’s revenue in the short run.

However, we are more concerned with the long-term structural decline in sales and net income. After growing for decades, Wal-Mart’s revenue and net income have both flat lined or even declined in recent years. Having been accustomed to double-digit annual growth, Wal-Mart’s 2015 revenue was $485.6 billion, up a mere 3.5% since 2013. Net income over the past 12 months totaled $15.09 billion, down over 7% from one year earlier.  We attribute the declining growth to Wal-Mart’s pricing, execution, E-commerce, and quality. 

For years, Wal-Mart has been struggling to find the right match between the product pricing and the product quality.  For the world’s largest 42-year old retailer, Wal-Mart should have found its “sweet spot” a long time ago.  More than four times Target’s size, Wal-Mart undoubtedly is the low-price retailer king.

In contrast, Target has been good at ‘cheap chic’ because it advertises fashion and experience ahead of its discount prices, and then execute it well at retail. Shoppers looking for better (quality) products will go to Target and expect to pay higher prices.  This would suggest that both retailers have been properly placed. Wal-Mart has the big data to know that for store locations close to lower-income areas, pricing is the key point to attract shoppers for their additional discretional spending.  For stores nearby middle-upper income areas, the product quality and favorable in-store shopping experience will drive the repeat traffic.

By the way, Target has a revenue growth of -0.01% (vs. Wal-Mart’s 3.5%) for the last three years, and a net profit margin of -0.95% (ttm) (vs. Wal-Mart’s 3.12%).  Why would Wal-Mart want to be Target?

However, lower prices for lower quality goods do not give Wal-Mart the excuse to give lousy services which have been their longtime reputation of poor execution. Traditional Wal-Mart shoppers might tolerate long checkout lines, disinterested employees, and often out-of-stock shelves.  But, customers who are most able to generate incremental spending in Supercenters and Neighborhood Markets need to be impressed with their shopping experience.

Since 2015, Wal-Mart invested $1.2 billion in labor, healthcare, and employee training, and the impact has been almost immediate. 70% of the stores have met the initial goals of customer experience scores set by management. It is not a coincidence that the investment was followed by an unexpected increase in traffic and comps (1.7% and 1.5%) in the most recent quarter.  Wal-Mart management has long known the causal effect that better in-store shopping experience produces more in-store revenue. They also plan to bring in an ex-Target executive as a consultant.

Finally, we cannot ignore the elephant in the room.  In 2015, Amazon’s stock surged more than 200%, the largest since two years after its IPO (1997).  Ironically, in 2015, Wal-Mart’s stock plunged more than 30%, also the largest since two years after its IPO (1972).

Like or not, Amazon is the new Wal-Mart.

Today, Wal-Mart’s revenue is still 5 times larger, but Amazon’s revenue per employee is nearly three times that of Wal-Mart.  Additionally, between 2013 and 2014, while the retail industry same store sales grew around 3.5% a year, e-commerce by 16%, Amazon grew an astonishing 28%.  For 2014, Wal-Mart ($12.1 billion) was ranked in third in online sales, following Apple ($20.6 billion) and Amazon ($79.5 billion). For 3Q2016, although the company’s e-commerce, Wal-Mart.com, contributed 15 bps to comps, which was still 5 bps lower than the second quarter. Both online sales and traffic were below expectation. Why would Wal-Mart think it can beat Amazon?

The real challenge now is whether Wal-Mart can strategically align its investment for e-commerce with its investment for in-store execution. Study after study shows that retailers with brick and mortar stores have better online sales than web-only retailers.  Shoppers will first go to the stores to touch and feel the product before they buy the product on, hopefully, the company’s website.  As a favorable in-store experience will increase both the in-store and online traffic, there is a feedback loop between the store sales and online sales.  Therefore, we like the fact that, over the next two years, Wal-Mart is increasing spending on its e-commerce business by $2 billion in new fulfillment centers and mobile apps with improvements in customer service.

The bottom line is then how well and how soon Wal-Mart executes these initiatives.  Given the upbeat recent earnings, our valuations indicate a fair value for WMT around $70.

“Attention Wal-Mart Shareholders: Another 10% discount on our stock.”

 

 

 

 

 

 

 

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