Wal-Mart Associate Options/Restricted Stock, Energizer Holdings, Jarden Corp., Abs in a Box and more!

Wall Street’s Lukewarm Reaction to Wal-Mart Annual Meeting is Shortsighted

Before, during and after Wal-Mart’s shareholder’s meeting we spent time with WMT management and Wall Street analysts (finance nerds) who evaluate the giant retailer and whose job is to advise mutual funds and legions of stockbrokers (flamboyant salespeople) on whether to buy or sell the stock. As former analysts (finance nerds) ourselves, we can offer insight into how Wall Street thinks (or doesn’t think).

Wall Street’s view is short-term, one-year, at most. As such, the messages they zeroed in on were that expenses would be higher and that comp sales (because of commodity price deflation) would be challenging this year. Thus, few were excited about prospects for the stock. Yet, if one views WMT through the lens of a business owner, associate, or long-term investor, a different picture emerges. First, consider why the stock has not budged in the past decade. (Read our full analysis here)

There are two lines on the chart depicting results from 1999 to 2009. The first line is EPS, which represent performance of the business – 12% EPS growth per year, that’s pretty good. The second line is Price/Earnings or P/E ratio. The P/E measures how much investor’s think each dollar of earnings are worth. During the late 1990’s investors were willing to pay $45 for each dollar of Wal-Mart’s earnings (much higher than Google’s P/E!).

WMT was not alone in this mania, as Wall Street bid up the shares of blue-chip companies like Coke, Proctor & Gamble and others to valuations that were out-of-line with those companies’ growth potential. It’s taken a decade, but the fast money has realized that they were overpaying for WMT’s earnings. Though EPS has been growing, it was being offset by a decline in the P/E multiple, keeping the stock basically between $45 and $50. Now, WMT has a P/E of 15x, which is about what the market and big, strong companies have historically traded at. Thus, looking ahead, it is likely that if EPS doubles so should the stock price—finally!

Wal-Mart EPS Growth, Stock Price and Investor Returns

With any investment, whether one buys the entire company or a single share of stock, the financial logic applied to the decision is the same, says Warren Buffett. There are more complex models, but here is a simple and concise approach.

At $50 per share, WMT’s 3.92 billion shares are collectively worth $195 billion. Because of its size, it is clear that WMT will not grow earnings at 38%, 34%,15%, and 12% like it did in the 70’s, 80’s, 90’s, and last 10 years. But, the company is highly profitable and seems capable of producing 6-8% EPS growth based on modest sales increases, steady margins, and using its billions in excess cash flow to reduce the number of shares outstanding. So, if you bought the entire company today for $195 billion, how long would it take you to get your money back? About 9 years. Here’s how. WMT is expected to produce $14 billion in net income this year, which, if grown 8% per year, would accumulate to $195 billion in 9 years -- that’s a 11% return on investment (1/9 = 11%) whether one share is purchased or the entire company. Of course, stock prices don’t necessarily mirror growth in earnings or value in the short term but tend to reflect that value over time.

But What About My Options & Restricted Stock?

Astute investors recognize the quality and depth of managerial talent at Wal-Mart. However, the company is at an inflexion point. The stock price performance over the next 3-5 years is critical to retention and therefore, vital to the company’s future. Although WMT has increased pay and grown managerial talent from within and from outside, the stock price, which is the engine of wealth creation, has been stuck in neutral.

Most associates don’t become rich from their salaries. However, thousands of current and former employees have become wealthier than they ever imagined because they owned the stock. It may be the biggest elephant in the room, but there’s an expectation that the stock will move higher.

In the past 10 years, WMT has granted its associates approximately 145 million options, restricted stock, restricted stock rights, and performance shares, handing over ownership of 4% of the company to associates. Currently, 74 million of these share awards are outstanding at an average grant price of $49.00.

If the stock price is now more likely to track EPS growth, and if EPS growth is likely to be 6-8% per year, then it follows that the value of the company would increase by about (at least) $4 per share over each of the next few years. Multiplying the 74 million in share awards by $4 equals about $300 million in additional annual compensation/wealth for associates. Keep it up for a few years and associates are a billion dollars wealthier. Imagine what that would do for the economy in Northwest Arkansas! It might be a boon for sellers of jewelry, boats, RV’s and other discretionary items.

CPG Investors Avoid Recent Onslaught of Stockholder Dilution

Recently, common stockholders of General Motors have seen their entire investment essentially wiped out, and several companies within the financial industry have issued significant amounts of stock to raise money. Unless existing shareholders receive new stock for free or purchase more when these deals are priced, their ownership (and hence, the value of their investment) will be reduced. According to data from IPO Monitor, we estimate that year-to-date approximately $20 billion has been raised by about 85 public companies that sold additional stock to raise money; and the average shareholder saw their existing ownership diluted by about 15% if they did not pony up additional money to buy more stock. Not surprisingly, financial companies and real estate investment trusts (REITs) comprised nearly one-half of the companies and dollar amount raised.

We believe that so far the damage to CPG investors has been minimal, with notable offerings from Energizer Holdings (ENR) and Jarden (JAH). ENR issued new stock in May at a price of $49. After paying investment banking fees of $25 million, net proceeds of $510 million will fund the purchase of the Edge/Skintimate shave prep business for $275 million from S.C. Johnson & Son, and reduce ENR's existing $2.8 billion in debt. Dilution to existing ENR shareholders was around 17%. Jarden issued shares at $17.50 in April, netting proceeds of $203 million. JAH intends to use the money for general purposes and to reduce some of its $3 billion in debt; dilution to shareholders was about 16%.

Best use of the word “fissiparous” in a Scholarly Publication

While we don’t usually hang out with the crowd that wears bowties, v-neck sweaters under their suits, are named Thurston and refer to their wives as “lovie darling” (not that there’s anything wrong with that), we discovered a very insightful article on globalization and geography in a recent issue of Foreign Policy (read full article here). Unlike conventional thinking (e.g., NY Times bestseller, The World is Flat), the author constructs a case that globalization actually makes geography (and natural resources) more relevant, not less relevant. If you like politics, history, and global markets, this article is right in your wheelhouse. Source: Foreign Policy.

Department of Corporate Doublespeak

Ted Eliopoulos, head of CalPERS’ real estate portfolio (CalPERS is the nation’s largest pension fund with some $170 billion in assets invested on behalf of state of California employees) remarked in an interview: “No one in the marketplace knew how swiftly the housing market would fall – not the Federal Reserve, not the Treasury.”

Translation: “I have just invested tons of money at the absolute top and lost 103% I put into the deals due to using recourse debt. I am a moron. I could not have predicted the housing market would fall. No one could have…other than Ron Paul, John Paulson, Robert Shiller, and Long or Short Capital.” source: Long or Short Capital

Abs in a Box

Its swimsuit season, but forget doing the crunches. We saw an ad for Abs in a Box recently. For a mere $69, you’ll receive a kit containing contouring shades, semi-permanent stain, sprays and a mini Kabuki Brush to paint on your new, chiseled abs. Just when we thought we had heard of everything…

And One More Thing…

Father’s Day is next week and this awesome gift is (at least for now) the one missing item from my outdoor gear collection (aka, my garage). Wilderness Solutions of Shortsville, NY manufactures hand-made fire-starting pistons (see the video here) that generate heat via compression. Though mostly used by survivalist types, guys, you can impress your friends & neighbors with your pyrotechnic skills when you whip one of these out to light the grill. -- Scott

Quote of the Day:

On the topic of fire, Jamie Dimon, CEO of JP Morgan delivered this one-liner when questioned why JP Morgan paid so little to acquire the then-imploding Bear Stearns:

“There’s a difference between buying a house and buying a house that’s on fire.”

Have a thought or comment? Give us a call or email.

Scott Alaniz, CFA
scott@bostonmmm.com

Joe Chumbler, CFA
joe@bostonmmm.com

Rogers (479) 657-6940

Information in this report has been obtained from sources that we believe to be reliable. Boston Mountain Money Management does not guarantee its accuracy or completeness and assumes no responsibility for actions taken with respect to information contained herein. The authors held a position in Wal-Mart Stores at the time of this newsletter.

Wal-Mart: Can the Stock Double?

From July 1971 until July 2000, WMT’s share price grew from $0.02 to $44.00 (adjusted for stock splits), a return of 2,200% – One of the best 30-year stock performances ever. In the nine years since that time, the stock is up a mere $6, or 14%. What happened? Are the shares capable of producing an attractive return again?

At first glance, WMT shares appear to be a poor investment with little hope for strong gains. The company is struggling under its own heft, same-store sales growth is modest, and management has deliberately slowed square footage growth. A closer look at the facts reveals otherwise – a compelling opportunity, largely ignored by the mainstream investment community.

The Company Controls the Earnings, Not the Share Price
Stock price is determined by two factors. First is the level and growth rate of earnings per share. Second is the price that investors’ pay for each dollar of earnings per share – the price earnings ratio (P/E). Just as a consumer buying a house typically wants to pay according to a “price per square foot”, so too do investors buying a stock want to pay according to a “price per dollar of earnings per share (EPS).” And stocks can be overpriced just like homes.

Would you pay $300 per square foot for a typical house in Rogers, AR today? Hardly, since that’s about three times the appropriate price/sq. ft. for a typical home. But during the stock market bubble in the late 1990s, irrational investors were indeed paying three times the appropriate price per EPS for stocks like WMT. In 1999, WMT was earning about $1.00 per share and the stock was at $45. Irrational investors were paying $45 per dollar of EPS – three times the normal market price of $15 per dollar of EPS.

As shown in the chart below, WMT’s stock price is essentially unchanged from 1999, even though both factors that affect the share price have changed dramatically. Why? Because change in one factor offset change in the other.

The company has performed well – EPS has tripled from about $1.00 to $3.40. It’s taken nine years, however, to let the air out of the bubble, but investors have finally become rational again. The price they are willing to pay for each dollar of EPS is 1/3 what it was in 1999. Now that Wal-Mart’s P/E has moved from an unrealistic 45x earnings to a more normal 15x (remember, the historical average P/E is 15x for all companies), investors do not have to fight the headwind of a shrinking P/E ratio. This means that in the future WMT’s earnings growth should produce more or less matching increases in the stock price over time.

Now that we have determined that the lackluster stock performance has been due to investors’ nine-year return to rational pricing, let’s take a closer look at the performance of the company during that period. Since 2000, WMT has generated $94 billion in earnings. It paid shareholders $21 billion in dividends and kept $73 billion to invest in the business to produce earnings growth. Of the $73 billion at their disposal, the Company spent $31 billion repurchasing its own shares and invested the remaining $42 billion in the business – for new stores, acquisitions, and such.

The question to ask, and what Wall Street ignores is, “Is WMT management making bad investment choices?” The numbers say no. Since 2000, earnings have increased by $7.9 billion (from $5.3 billion to $13.2 billion last year). Earning an additional $7.9 billion on $42 billion invested in the business is an 19% return on investment. These returns demonstrate that management has made good decisions with shareholder’s money (aside from a few mistakes in the International Segment, addressed shortly).

Can the Stock Ever Go Up Again?
Wal-Mart’s historic 2,200% share price gain was fueled largely by its gain in EPS. Since EPS growth ultimately drives the share price, how fast can Wal-Mart grow EPS over the next 5 – 7 years?

To grow EPS, a company has three, and only three, levers at their disposal: grow sales, improve the profit margin, and reduce the number of common shares outstanding. Consider a reasonably conservative scenario for Wal-Mart over the next six years: Sales growth is driven mainly by growth in square footage (new stores). In 2007, Wal-Mart retrenched, reducing its planned growth in square footage from a 12% clip to about 6% - 7% per year. The company could not manage adding that volume of square footage growth and effectively manage its existing stores. Service faltered, evidenced by declining same-store sales. Give management credit for acknowledging that limitation. The decision to move into the slow lane has helped the company better manage its existing store base and resulted in improved same-store sales growth, which has improved profits and investor sentiment towards the stock.

Profit margins have been pretty stable over the past decade and we are not expecting a significant improvement. Thus, expecting earnings growth to track sales growth is reasonable. However, the best chance for margin improvement is at the Company’s International Segment (25% of sales), which has underperformed the domestic business. Return on Assets for the International Segment was 8.2% last year compared to 22.2% earned at U.S. stores. The good news is that International is getting better as WMT has exited some markets they couldn’t make acceptable returns in. If the company can just get from “below-average” to “average” returns at its International segment, profits could improve nicely.

The easiest way for WMT to add to EPS is to buy back its own stock, which makes more sense the lower the price paid for each dollar of earnings. While it is uncertain just how much stock WMT will buy back, the Company has the capability to acquire $50 billion in stock over the next six years while maintaining its financial ratios at the current conservative level. What is certain is the powerful impact buying back shares has on EPS growth. With projections of around 8% annual earnings growth, reducing the share count by 15% boosts per share growth of earnings to 12% per year.

Finally, apply a reasonable P/E multiple to WMT’s estimated future EPS of about $6.75 ($22.2 billion in earnings divided by 3.3 billion shares - see table). It is impossible to predict what P/E Wall Street will assign the company. But, assuming that investors will continue to pay a rational price of $15 per dollar of EPS, that $6.75 in EPS puts the stock worth $101 per share in 6 years. Plus, an investor would collect another $7.00 or so per share in dividends. With the stock at $50, that’s a potential doubling of an investment over the next 6 years.

What can go wrong? The biggest risk is that Wal-Mart overpays for a big acquisition or makes several small acquisitions that are distractions to the core business.

Have a thought or comment? Give us a call or email.

Scott Alaniz, CFA
scott@bostonmmm.com

Joe Chumbler, CFA
joe@bostonmmm.com

Fayetteville (479) 251-8400
Rogers (479) 366-4474

Information in this report has been obtained from sources that we believe to be reliable. Boston Mountain Money Management does not guarantee its accuracy or completeness and assumes no responsibility for actions taken with respect to information contained herein. The authors held a position in Wal-Mart Stores at the time of this newsletter.