During the past decade, investing in housing, the stock market, or gold has been an eye opener for U.S. consumers. The value of houses soared and then crashed. Gold slumped and then surged ahead. Oil prices rose to unimaginable peaks and then fell by more than -75%. All the while, shares of Wal-Mart (NYSE: WMT) just sat there.
Despite hundreds of upgrades and downgrades by analysts over the last ten years, shares of Wal-Mart are right where they were when Bill Clinton was still in office. To understand why shares haven't moved before and why they may start moving upward now, you need to break this story into three Acts.
The first act involves an unknown retailer from Arkansas that was founded in 1962, came public in 1972, and went on a never-ending winning streak that made it the world’s largest retailer by the late 1990s. By then, the retailer had grown so large that it became harder and harder to keep growing at a double-digit rate. Yet investors mistakenly assumed that Wal-Mart would never slow down, and awarded the stock very rich valuations.
And then began Act Two. Over the ensuing decade, Wal-Mart kept growing, but at an increasingly slower pace. Management pulled out every trick in the retailer’s handbook, not always to good effect, and large mutual funds began to look elsewhere for new opportunities, figuring the stock did not deserve an especially high price-to-earnings ratio (P/E). So the P/E ratio on its shares kept shrinking, even as profits were slowly rising. Rising profits plus a lower P/E spells a flat stock price.
Yet a case can be made that Wal-Mart is moving into Act Three. Its new strategies are showing real promise, and could set the stage for a moderate rebound in sales and profit growth rates.
In the last several years, Wal-Mart moved away from its image as the lowest-cost provider and tried to move its image upmarket. Meanwhile rivals such as Target (NYSE: TGT) managed to lower prices and maintain a fashionable reputation. Wal-Mart was at risk of catering to neither value nor fashion shoppers. Lesson learned. Starting in March, Wal-Mart began to aggressively roll back prices, an effort that has really picked up steam over the last few weeks. The company just provided a comprehensive update to investors, and management finally appears to have pulled the right levers this time.
The main goal of the price rollback is to drive store traffic. But if lower prices simply quash profit margins, then it’s a Pyrrhic victory. Wal-Mart managed to find a range of efficiencies that led to lower operating costs. As a result, management notes that the low-pricing strategy is boosting sales while keeping margins flat. For example, the company’s grocery segment has begun to buy a lot more local produce, which can be bought for much less than it would cost to have it shipped in from across the country or across the world. The net result: Wal-Mart’s produce prices have been steadily dropping as savings are passed on to customers. And that’s boosting produce sales and driving more traffic to the rest of the store.
Wal-Mart no longer reports monthly sales, and investors remain focused on the fact that same-store sales in the most recent quarter fell -1.4%. Yet management was pretty clear that the current quarter is going quite well. If their body language is being correctly read, same-store sales should show nice gains this quarter.
Right now, investors think that Wal-Mart will boost sales around +5% this year and next, due solely to robust growth in its international division. Management noted last week that sales in Brazil and China are trending very well, and sales in Mexico and Canada are also above plan. The company is improving its global sourcing for all of those regions, and thinks it can improve its inventory turns and cash flow in the international business.
But if the international business is doing well, and the U.S. business is picking up, it’s fair to wonder if analysts are being too conservative, forecasting sales to rise +5% each year and per-share profits to rise around +10%. Analysts at Smith Barney think so. They think consensus forecasts are too low, and Wal-Mart should earn around $5.40 a share next year, well above the $4.86 consensus. Shares trade for less than ten times that street-high estimate. The consensus estimate is likely too low, as it doesn’t account for a new $15 billion stock buyback program that represents about 7% of shares outstanding,
So what is a fair way to value this stock? If sales and profit growth are weak, then you could assess the stock by its yield (which is free cash flow divided by the market cap). Free cash flow should hit around $11 billion this year, implying a 5.8% free cash flow yield. ($11 billion/$189 billion). If you assume that Wal-Mart’s cash flow won’t sink, then that yield looks a lot more attractive than the fixed-income yields you get from bonds and CDs these days.
But if sales and profit growth are indeed picking up, reversing the declining growth rate trend, then a P/E ratio is suitable. As noted above, shares trade for a little less than 10 times next year’s projected profits (according to Smith Barney estimates), even though per-share profits could start rising at a +15% pace (assuming a sales growth rate at half that level). If the multiple finally starts to move up to 12 or 13, then investors are looking at +20% to +30% upside.
Action to Take --> After a decade of moving sideways, it may seem foolhardy to predict a big run for shares of Wal-Mart at this point. But a combination of rising sales, improved sourcing, tighter expense control and a reduced share count make this mega-retailer poised to surprise on the upside.