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.
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