Headwinds Continue for Undervalued Wal-Mart

 Wal-Mart (WMT) reported fourth-quarter results that were generally in line with the expectations laid out in late January, when the company lowered its fiscal 2014 guidance because of one-time charges and a larger-than-expected headwind from food stamp cuts. Management also provided guidance for fiscal 2015 that was slightly below our expectations, but we don't expect lower near-term assumptions will have a material impact on our $80 fair value estimate. Wal-Mart could face several challenges over the next few quarters, but we think this wide-moat company's cost advantage should allow it to defend its competitive position. The shares currently trade at a modest discount to our fair value estimate, and we think patient investors could benefit from increasing exposure to this low-uncertainty name.

Wal-Mart U.S. comparable-store sales decreased 0.4% in the quarter, while comparable-store sales at Sam's Club decreased 0.1%. We believe these lackluster results reflect challenging macroeconomic conditions, harsh weather, cuts to food stamp benefits, and aggressive price investments. Wal-Mart's scale economies will allow the company to continue investing aggressively in price while sustaining excess returns on capital. However, we are cautious that the volume uplift from these investments will be muted over the near term; reductions to food stamp benefits could counteract Wal-Mart's lower prices and ultimately result in relatively flat food volume.

The gross margin (excluding membership fees) contracted 50 basis points, primarily because of Wal-Mart's aggressive holiday price investments. We don't expect material gross margin expansion in fiscal 2015, as Wal-Mart remains highly focused on ensuring that its everyday low price value proposition reinforces customer confidence in the banner. Perceived price leadership supports Wal-Mart's brand equity, and the resulting volume growth helps the firm leverage its fixed cost structure to lower per-unit costs.

U.S. Tethering Strategy Leverages Wide Moat
In the United States, Wal-Mart plans to develop multiformat store "ecosystems" that serve all trip types--stock-ups at Supercenters, basic food trips at Neighborhood Markets, and fill-in trips at conveniently located Express stores. Wal-Mart intends to strategically open new Neighborhood Market and Express (convenience) stores in areas where other small-format competitors--predominantly the dollar stores--have built a presence over the past few years.

This tethering strategy is simple yet powerful, because Wal-Mart can efficiently leverage its store footprint to compete online and offer a much wider product range across its store formats than other small-format competitors can offer. The company can use storage space in existing Supercenters to cross-dock products for smaller-format stores. The strategy has three benefits: It reduces inefficient trips to smaller stores, it allows Wal-Mart to offer customers considerable product variety in small formats, and it utilizes Wal-Mart's asset base to distribute products sold online. Wal-Mart should be able to leverage back-office systems, drive logistics savings, and potentially lower capital expenditure requirements without reducing the revenue opportunity. All of these benefits, if realized, should help Wal-Mart to support its wide moat, which driven by the firm's price leadership.

Wal-Mart's strategy to improve international returns and drive comparable sales growth at Sam's through merchandising is sound, but success 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 more online sales. The company intends to implement a much more precise merchandising strategy whereby it will add many new products each month rather than manage through a particular season of the year. The challenge will be profitably reallocating store space more frequently, although consumer data should help. On the international front, achieving returns comparable with those in the U.S. may be difficult to achieve, as competition is quite fierce and international scale advantages do not appear as robust as in the U.S.

Cost Advantage Stems From Volume Purchasing Power, Massive Scale
Wal-Mart is the largest retailer in the world with more than $450 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.

Wide Moat, Stable Cash Flow Bring Low Risk
We assign a low fair value uncertainty rating to Wal-Mart, primarily because of the firm's Wide Economic Moat Rating and stable cash flow generation. That said, competition could intensify over the coming years, particularly if consumer income growth remains sluggish and existing players become increasingly price competitive (at the expense of margins) to drive traffic into stores. This aggressive price competition could also exacerbate the challenges posed by volatile commodity prices; the firm may be unable to pass through higher input costs and preserve margins without losing share. International business operations leave the firm exposed to various geopolitical risks, inflationary pressures, currency fluctuations, and differing regulatory standards. Finally, multichannel shopping could challenge Wal-Mart if consumers increasingly shift spending online; the firm needs to generate sufficient in-store sales to justify operating with a large store footprint.