Wal-Mart (WMT) (51.56, $202 billion market value) had a spectacular year in 2008, rising 18% in price while the overall market eroded 37%. Going into a year with a relatively low valuation at the time and benefitting from the precipitous decline in gasoline prices and stimulus checks that boosted the wallets of their customers as well as their low-price position that attracted consumers looking to trade down, it isn't that surprising that the stock was in strong demand. On January 8th, though, the company signalled that all is not well in Bentonville, sharing a stark reminder how challenging the economy is for even the best positioned. The stock reacted accordingly and fell sharply, but I expect this to be the first of many resets that will hurt the stock further.
Before I explain myself, though, do me a favor an take this pop quiz (no cheating!):
How much net debt does WMT have?
- a) None (they have more cash than debt)
- b) Very Little (less than $10 billion)
- c) Better than most companies ($17 billion or 20% Debt to Capital)
- d) Typical for S&P 500 Companies ($25 billion or 28% Debt to Capital)
- e) More than average ($41 billion or 39% Debt to Capital)
Do you have your answer? I don't spend a lot of time analyzing very large companies typically, and I would have guessed b or c. The correct answer, though, is actually e (more than average). As anyone who follows my thinking, especially of late, many of our companies have been too liberal when it comes to the use of debt. While debt has its role in corporate finance, investors need to understand the role of debt in the companies in which they invest. In the case of WMT, they use debt to enhance the earnings power of a very large and mature company, which isn't too surprising. Additionally, they have been boosting EPS for several years by reducing share-count and have taken up the pace a bit this year. According to their most recent 10-Q, the company has repurchased $10 billion of stock since they authorized a $15 billion purchase over time on May 31, 2007, representing a significant premium to free cash flow after dividends. I'll come back to this point later, but I wanted to share this information initially in the event, like me, you weren't exactly fully sure how WMT was growing its EPS.
The issues I see with WMT fall into three areas: operational challenges, valuation concerns and a weak chart . WMT margins are pretty low (not a surprise given the nature of the business), but they have been stable for quite some time. Pre-tax margins have been 5%-6% roughly for the past 18 years. Recently, they have been under moderate pressure and are near the low-end. The challenging economic environment could pressure them more significantly. Besides lower through-put with consumer demand flagging, customers could demand better pricing as piles of goods stack up at competitors that are either liquidating or in fear that they will be liquidated if they don't move as much inventory as possible. Beyond pressure on the operating margin (which has moved from the high 7s to the low 7s already this year), the company could see challenges from higher potential funding costs as it moves its short-debt out. Finally, the company's suspension of its large repurchase program removes some of the EPS boost experienced over the past few years. I expect that EPS estimates, already down after the pre-announcement, could drop further and am predicting that fiscal 2011 will come in closer to $3.50 rather than the $3.98 consensus.
While it is difficult to say that WMT is egregiously overpriced given its PE multiple of just 14.3X, that is a premium to the market for a company with below-market growth potential in the long-run. As I have been conveying, I have been paying a lot more attention to balance-sheet valuation metrics and would note that 4X tangible book value is no bargain in the event earnings do erode even worse than I expect. I believe that a year-end valuation for WMT consistent with this market would be 12X my FY11 estimate or 42. This represents a decline of almost 19%.
The chart indicates that the long-term moving average rolled over and served as resistance before the gap down. What's most concerning is that the stock has done so well against the rest of the market for the past two years that it has lots of room to be sold by institutional investors should they want to do so (before becoming a bad "relative" investment). Additionally, with an above-market valuation, there is little reason not sell on that basis should one become inclined. Breaking 50 looks to be a potential catalyst for the next leg down, while the stock should struggle breaking 54.
WMT has been one of the few safe havens for large-cap investors over the past year. The fundamentals have shifted, and the company is vulnerable to this economic downturn even if to a lesser degree than others. Its balance sheet, which has seen tangible equity relative assets decline from 38% to 30% over the last 10 years, isn't nearly as pristine as it should be. The stock has rolled over now and appears to be on the edge of a potential sell-stop trigger. Its valuation isn't nearly low enough to support it any further bad news at this point. While I am not short the stock, it seemingly supports my overall bearish views. I shared a forecast that stocks will fall 15-20% this year, which, if correct, means WMT will actually be slightly-worse-than-market performer should it end the year at my target of 42.
Disclosure: No position