Tuesday, May 16, 2006
May 12 2006 - Financial Times
The greatest investment opportunities are seeded not by warm sunshine but by chilling rain. It has been freezing and pouring in Wal-Mart’s neck of the woods. To say Wal-Mart is not loved is a serious understatement. It has been convicted and fined $172m for refusing employees in California rightful overtime breaks, it has been criticised for paying low wages and being stingy with health benefits, its older stores are so shabby they could easily be confused with K-Mart stores in the 1990s.
To add fuel to the fire, its stock has been drifting down since 1999. The public perception has grown so negative that after buying stock for my firm I got a note from a client asking me not to tell his children he now owns Wal-Mart stock.
All this negativity surrounding the largest retailer in the world has created a great buying opportunity.
Its future is still bright. Wal-Mart’s biggest competitor is Wal-Mart itself. It has an enormous presence in the US. It is very hard for the company to open new stores without having a effect on sales at its existing stores. But in spite of its great geographic presence Wal-Mart currently appeals mostly to lower income demographics, and this is where things will change the most. Wal-Mart has three broad groups of shoppers: loyalists, who do most of their household shopping at Wal-Mart; selective shoppers, who buy most of their grocery and staples at Wal-Mart but don’t cross the aisle to the higher margin merchandise such as apparel and electronics; and the sceptics, who visited stores and were disappointed by the lack of cleanliness and appealing merchandise.
With its gigantic store base, it will only get harder to increase sales from new store openings. Instead, Wal-Mart is trying to widen its customer base and boost sales growth at existing stores – the cheaper, high return on capital source of growth.
In the past all its stores were indifferent to the demographics (defined by level of affluence, ethnicity, and so on) that they served. All stores carried the same lower quality merchandise at the best possible price. Although Wal-Mart’s core base of less affluent customers wanted the lowest price, the more affluent middle class – selective shoppers and sceptics – were looking for a value proposition: quality merchandise at great prices.
Things are now about to change. Over the next 18 months Wal-Mart will spend billions of dollars on remodelling 1,800 stores – almost half its US store base. No more K-Mart-like stores, it will focus on selective shoppers and sceptics by stocking stores to fit the demographics. This may hinder some of Wal-Mart’s hallmark efficiency but it should bring new, higher margin same-store sales. Cleaner, better, more appropriately merchandised stores will attract new customers – the sceptics – and encourage shoppers to cross the food aisle and spend more.
As initiatives take effect and the shopping experience improves, Wal-Mart will be taking market share from upper scale retailers, the same way it stole market share from Toys-R-Us in toys.
This remains a quality investment. Wal-Mart’s distribution efficiency and sheer size provide an incredible competitive advantage making it the lowest cost producer. Despite all the negative publicity Wal-Mart is still perceived to be a high quality company, with strong balance sheet and high return on capital.
The stock looks like value for money. It has been drifting down since 1999, not because company did not do well – earnings more than doubled in six years – but because in 1999 the stock was loved to death by Wall Street, sending its valuation 54 times earnings. It took six years and a lot of earnings growth to bring its p/e to 16 times its 2006 earnings – its lowest level in 20 years!
International markets, which represent close to 20 per cent of Wal-Mart’s sales, will be another very important growth engine. International sales, at $60bn, have almost doubled in the last five years. Although margins overseas are lower than in the US, they have been rising as higher sales bring improved operating efficiency.
Wal-Mart can deliver 10-14 per cent earnings growth, depending on the degree of success of its new initiatives. The Street expects 14 per cent. Of this, 5-8 per cent would come from opening new stores domestically and internationally, 3-6 per cent from same-store sales and another 1-2 per cent from share buybacks. In addition Wal-Mart pays a 1.5 per cent dividend yield, which has been on the rise in line with earnings growth.
Finally, this is a defensive stock. In economic uncertainty, Wal-Mart’s customer base should balloon as budget-conscious consumers flee there in a quest for savings. A similar fate will await investors, as the defensive characteristics of the stock and a very appealing valuation will attract investors if there is a correction in the overall market.
Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in Denver This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.