Tuesday, May 16, 2006

Don’t be downbeat about Wal-Mart

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.

Thursday, May 11, 2006

Government Goes Medieval on Telecom New Zealand

By Vitaliy Katsenelson, CFA
May 5, 2006 - The Motley Fool
A political risk is present in shares of any government-regulated company, but it came to fruition for Telecom New Zealand (NYSE: NZT) when the New Zealand government unbundled the local loop. Unbundling a local loop is a fancy phrase for requiring an incumbent telecom provider to open its networks to competition at cost. But maybe, just maybe, it created a very unique buying opportunity for Telecom New Zealand's shares.
The competitive telecom landscape in New Zealand is very different from the rest of the world. Let's review.
New Zealand is a very small country with a population of four million people. Hidden on two mountainous islands in the South Pacific, its geography has created a very unique competitive environment for the telecom services. Cable competition -- which has been gradually eating away at American counterparts Verizon (NYSE: VZ) and AT&T (NYSE: T) -- is virtually nonexistent in New Zealand, since cable proved to be an uneconomical route because of the relatively small market size and large, rough terrain. For the same reasons, Telecom New Zealand has only one competitor on the wireless side -- Vodafone, where both companies split the wireless market share in half.
The telecommunication business is not much different from a cargo plane trying to take off on the runway. The heavier the cargo that the plane carries (the fixed costs) the longer the runway (number of customers) required for the plane's successful takeoff. Scale is a must in the telecom business, and ability to achieve the scale is tremendously limited by the relatively small market size. There is only space for one runway in New Zealand's telecom landscape. And the size of any new runways is limited by the success of the existing players.
Over the last couple years, Telecom New Zealand has been cutting prices on DSL services, which fueled DSL subscriber growth exceeding 100% a year. In March, Telecom New Zealand cut DSL prices to the point that it rivals much inferior dial-up. This move should only accelerate DSL subscriber growth over the next couple years, since dropping dial-up for DSL becomes a no-brainer decision.
Despite the apparent urgency of the government's action, it will take several years for the decision to come into effect, since a lot of details have to be ironed out. This will give Telecom New Zealand plenty of time to increase its DSL penetration to at least 50% of the consumer market -- from today's 20% or probably even higher -- since Telecom New Zealand will try to capitalize on this window of opportunity and step up its DSL marketing efforts.
Any new entrant going after the DSL or voice market will have to spend a considerable amount of money to put its equipment in Telecom New Zealand's network operating center, and then it will have to try capture a significant market share of a relatively small market (where incumbent Telecom New Zealand already has a large market share) to recoup that cost. In reality, very few players are willing to take such risks. Telstra -- an Australian counterpart -- already has operations in New Zealand and is speculated to enter the market once it is deregulated. However, it appears that it has its hands full with its core Australian operations. Smaller players are likely to make some waves, but their success will be very limited, since they lack the scale to compete with Telecom New Zealand.
NZT shows resilienceThe decision to unbundle the local loop made little sense, though it was expected by many (including the company). What was not expected is the decision to force Telecom New Zealand to provide naked DSL. Naked DSL means that Telecom New Zealand is obligated to offer DSL services even to the customers that don't subscribe to the dial tone and pay for line rental. This means that competitors will be able to offer VOIP service over the company's phone lines. However, things may not be as bad as they seem:
  • Telecom New Zealand is working on its own VOIP solution, and it will have a several-year head start to sell it to its customers before competition enters the market.
  • As soon as the call comes off the Internet on Telecom New Zealand's last mile (which Telecom New Zealand owns) a competitor VOIP provider has to pay for it.
  • In France, a year and a half after Naked DSL was introduced, only 8% of the customers have taken the offer and canceled their phone line.

Though it appears that Telecom New Zealand is powerless to fight the government on this ruling, it holds a lot of political leverage:

  • As the largest company in New Zealand, it accounts for close to a quarter of the New Zealand stock market's capitalization. A significant drop of Telecom New Zealand shares over the last couple days had a tremendous impact on the NZ stock market.
  • It is the largest employer in New Zealand. The new law may force the company to cut costs -- and potentially start some unpopular layoffs. I believe Telecom New Zealand will have no problems with blaming politicians for the layoffs.
  • The company has made it clear that if the new laws are instituted it will stop investing in New Zealand, since it won't be to recoup its investment with the new laws. It will not invest in a new fiber-to-home network -- the future of telecom. And if a regulated incumbent abstains from making this multibillion dollar investment, nobody else will. This will derail the increase in available broadband speed in New Zealand, which is, ironically, the outcome politicians are trying to accomplish.

Future still looks brightIn spite of apparent certainty that the new ruling brings, investors just had a small peek at the worst possible outcome of proposed regulation. But it's always darkest before the dawn, and I believe the news flow will not get any darker. Today's valuation factors in a very high market share loss, which is very unlikely.

The stock success is largely driven by its super-sized dividend. The core ($1.93) dividend appears to be secure. If Telecom New Zealand decides to rollout the next-generation network, it can finance it from existing cash flows (after paying for capital expenditures and core dividends it still has a couple hundred million in U.S. dollars leftover), cost cutting, and possibly from lowering or cutting the special dividend of about $0.27 a share. (Since the special dividend was an added bonus, I never counted it in my analysis.)

Once the political landscape softens, which I believe it will, Telecom New Zealand will be making an investment into a next-generation fiber network, which has a hidden kicker -- it will allow the company to bring television services to New Zealand customers. This may extend top line growth for Telecom New Zealand for years to come.

All that said, politicians are infamous for making decisions that improve their chances of being reelected, but hurt the general public in process. Let's hope the consequences of this political decision won't be hurting consumers years later -- when today's politicians are likely to be out of office, sipping margaritas on the beach.
Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He also writes for the Financial Times and Minyanville.com. Both he and his firm own shares of Telecom New Zealand. The Motley Fool has a disclosure policy.
Vitaliy N. Katsenelson, CFA

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.