World's Largest Retailer Defends Its Turf

With unrivaled scale,

After reviewing Wal-Mart’s first-quarter results, we don’t expect a material change to our wide moat rating or our $83 per share fair value estimate, as the firm's profit drop and outlook were in line with our expectations. Having fallen after the earnings release, Wal-Mart's shares trade at a 7% discount to our fair value estimate. Given our low uncertainty rating and the less attractive valuations for other retailers, we suggest that investors start looking to build a position in Wal-Mart.

Investments in e-commerce and labor, along with currency headwinds, will weigh on profit growth over the next 12-18 months, but we see room for long-term upside as sales increase at the same time investments moderate. Investors are justified in focusing on whether Wal-Mart's investments ultimately drive sales growth, but we think many market players are expecting these long-term capital investments to drive improvements at a much faster rate than a firm of Wal-Mart's size is likely to deliver.

For example, wages, which Wal-Mart raised and will increase again in fiscal 2017, appear to be part of a broader strategy to drive employee productivity. While labor cost increases hit immediately, improvements in customer sentiment, traffic, and spending are likely to follow at a lag. That said, we don't believe the market is giving Wal-Mart enough credit for its potential to leverage higher sales to improve its brand image--a positive for its brand intangible asset--and to expand its margin longer-term.

Similarly, e-commerce investments will remain elevated over the next two years, with fiscal 2016 representing the peak of e-commerce investments. Many of them, such as Wal-Mart’s decision to offer free online shipping (in three days or fewer) for a $50 annual fee, are in pilot mode, limiting the impact on consolidated results over the near term. However, given changes in consumer shopping preferences and the multichannel sales opportunity that e-commerce poses, we think these investments are vital.

We were encouraged by improving results at Wal-Mart U.S., and we see room for further comp upside over the medium term. Wal-Mart U.S. comp growth came in at 1.1% during the quarter, and we expect the firm to sustain this level of growth over the near term; traffic (up 1.0%) and modestly higher average tickets (up 0.1%) mostly drove the growth. Our optimism about medium-term comp upside stems from Wal-Mart's awareness that its customers are using lower gas prices to pay down debt or build up savings. We expect comparable-store sales growth to accelerate slightly over the medium to longer term, as contentment with debt levels and savings could prompt consumers to reallocate cash flow toward products sold in Wal-Mart's stores.

Sam's Club once again had the most disappointing results, with comparable-store sales increasing a mere 0.4%. Sam's Club traffic declined during the quarter, driven by declining traffic from business customers. Management cited weak economic conditions and less-than-ideal merchandising, but we think

Wal-Mart's international segment reported decent results, although currency headwinds weigh on the bottom line. Most markets reported positive results, with the exception of the United Kingdom. The U.K. grocery market remains intense, and Wal-Mart's Asda subsidiary has more demographic overlap with discounters Aldi and Lidl, which continue to take market share from traditional grocers. We expect weakness in the U.K. market to continue, but we think Asda's e-commerce capabilities are sound, allowing Wal-Mart to leverage these strengths to improve its competitive position in other markets.

Superior Scale Defends Against Competitors Historically, Wal-Mart gained scale by saturating local markets in the U.S. and convincing consumers that its one-stop shop offered inexpensive products and convenience. Positive price perception bolstered brand loyalty and volume levels, driving down Wal-Mart's costs relative to peers'. The combination of a cost advantage and a brand intangible asset resulted in a virtuous cycle of improving results, despite few customer switching costs.

That said, the firm has been challenged by competitors offering low prices and convenience, namely the dollar stores and the online channel. In response, Wal-Mart is investing in e-commerce capabilities and expanding its footprint by opening smaller-format Neighborhood Market stores (basic grocery and pharmacy) so that it can serve all trip types (stock-ups at existing Supercenters and basic food trips/fill-in trips at small and medium-size Neighborhood Market outlets). We believe Wal-Mart's scale will allow the firm to operate efficiently in all channels and defend its turf.

Wal-Mart is also squarely focused on improving international returns and driving comp growth at Sam's Club through merchandising, but outperformance could be harder to achieve. Wal-Mart wants to drive more consumer trips to Sam's through increased membership, more trips by current members, and a greater degree of online sales. The challenge will be profitably reallocating store space more frequently (although consumer data should help) and fending off rival Costco. On the international front, achieving returns comparable with those in the U.S. may be difficult to achieve. Wal-Mart's expansion strategy is similar to the one it executed in the U.S., but competition is fiercer today and international scale advantages do not appear as robust as in the U.S.

Our Fair Value Estimate Is $83 per Share Our fair value estimate for Wal-Mart of $83 per share implies a fiscal 2016 price/earnings ratio of 16, enterprise value/EBITDA ratio of 8, and free cash flow yield around 5%. We continue to forecast overall annual domestic comparable-store sales in the 1% range (excluding changes in fuel prices) and about 2% total square footage, which equates to roughly 3% total revenue growth over the medium term.

We project operating margins to be roughly flat in fiscal 2016, as we expect that weak near-term comp growth, higher labor costs, and e-commerce investments could limit leverage opportunities. Over the long term, we think Wal-Mart can leverage its cost structure, but we think cost savings will be reinvested into lower prices. Thus, we forecast operating margins to average around 5.4% over the next five years, roughly in line with the 5.6% operating margin generated in fiscal 2015 and the three-year historical average of 5.7%.

Low-Cost Message to Consumers Supports Moat Wal-Mart has a wide economic moat because of the cost advantages that stem from volume purchasing power and massive scale. The company is the largest retailer in the world, with more than $485 billion in annual global sales, of which more than $300 billion is generated in the U.S. So, relative to other retailers, Wal-Mart has tremendous leverage to extract the most favorable terms possible from consumer goods suppliers, vendors, and manufacturers. Moreover, to gain access to the largest sales channel in retail, suppliers must tie into Wal-Mart's just-in-time inventory and logistics systems. Wal-Mart leverages its everyday low-cost advantages to communicate an everyday low-price message to consumers. We believe an intangible moat source stems from this messaging, as core consumers almost automatically perceive Wal-Mart to lead on price in most categories.

CEO McMillon Continues Wal-Mart's Established Strategy Former CEO Michael Duke, who previously headed the international division, retired at the end of fiscal 2014. Effective Feb. 1, 2014, Doug McMillon, previously the president and CEO of Wal-Mart International, took over as president and CEO.

Duke spearheaded "project impact," the company's initiative to shift consumers' awareness of Wal-Mart as solely a low-cost provider toward more of a value proposition. This effort had little impact on U.S. same-store sales, which had been declining since the fiscal second quarter of 2010 (July 2009), and the company has since regrouped to place a great deal of energy toward reinforcing its EDLP proposition. The company's $6 billion in price cuts, which helped support domestic comparable-store sales despite fierce competition, is the most notable example.

McMillon has been with Wal-Mart for more than 20 years, working his way up from distribution and merchandising roles at Wal-Mart U.S. to segment president and CEO of Sam's Club (2006-09) and, most recently, the international business. We don't expect McMillon to pursue a strategy that is materially different from the one outlined in the recent past; his long tenure at Wal-Mart and experience running the firm's global portfolio with vast distribution scale give us confidence that he will make decisions that reinforce the firm's wide economic moat. As such, we assign Wal-Mart a Standard stewardship rating, although we intend to update our analysis if the firm announces subsequent changes to its strategy or capital-allocation policies.

The board consists of 16 directors, 12 of whom are independent. Senior management compensation is driven mostly by variable performance that includes return on investment, pretax profits, domestic same-store sales, and international revenue growth. The CEO's compensation is within industry norms, especially given the size of the company. Walton Enterprises is the largest shareholder, with about 48.9% of shares outstanding, and consists of several Walton family members, including S. Robson Walton and Jim C. Walton, who is also on the board. There have been a handful of investigations into foreign business practices, and, the company has responded with programs to make sure employees and suppliers comply with the Foreign Corrupt Practices Act.