Wal-Mart Shares Look Undervalued

 Wal-Mart (WMT) reported second-quarter results that exceeded our expectations on the top line, but higher-than-expected health care costs resulted in operating profit coming in slightly below our forecast (operating margin contracted 20 basis points to 5.6%). Management increased its forecast for higher health care costs to $500 million (from $330 million initially) and incremental investments in e-commerce and technology infrastructure, which combined prompted management to reduce its full-year earnings per share guidance range to $4.90-$5.15 (versus $5.10-$5.45 previously).

We intend to update our near-term forecasts to reflect these higher costs, but still believe Wal-Mart commands a cost advantage over most of its rivals and don’t expect a change to our wide moat rating or $80 fair value estimate. Wal-Mart’s shares currently trade at a discount to our fair value, and while the firm faces several challenges, we think the market price doesn’t fully reflect the company’s potential to leverage cost advantages and brand equity while expanding in multiple channels.

Wal-Mart U.S. segment comparable store sales were flat during the quarter, as a 1.1% traffic decline was offset by higher average tickets. We believe that higher average tickets were fueled by modest inflation (despite a 70-basis-point headwind from SNAP benefit reductions), but traffic weakness still remains a concern of ours. Traffic remains positive at dollar stores, which have challenged Wal-Mart as of late, and Amazon continues to drive solid results.

That said, we think that Wal-Mart’s investments to build out small formats and e-commerce are sound, as we suspect that the traffic softness occurred at larger stores; Neighborhood markets generated solid (5.6%) comp growth driven by a 4.1% increase in traffic, while e-commerce sales were up by more than 20%. The company is on track to add an additional about 90 Express   this year as well, which should also help to bolster sales. 

At Sam’s Club, membership revenue increased 11.9% during the quarter, as membership renewal rates remained steady despite a membership fee increase in May 2013. Modestly higher (0.3%) same-store traffic was also a net positive at Sam’s Club, although comparable store sales were flat relative to last year due to a 0.3% decline in average ticket. That said, profit declined (down 10.2% excluding fuel) due to higher rewards program and health care costs, and we remain cautious that Sam’s Club will be able to expand operating margins over the long term. This banner faces considerable competition from wide-moat  Costco (COST), which not only generates sales per square foot that are double those of Sam’s Club, but is also sustaining mid-single-digit comp growth and could still grow its store base by one third.

Performance in international markets was solid, with sales up 3.1% and operating income up 8%. Of the firm’s top five markets (the U.K., Mexico, Canada, Brazil, and China), comparable store sales were up in all but China (down 1.6%). We were particularly encouraged by Asda’s 2.0% comp growth in the U.K., where intense price competition is driving down like-for-like sales growth and margins at most traditional grocers. Overall, we still believe that Wal-Mart’s wide moat is driven by the U.S. business, but if the firm is able to continue expanding its store base, we think it should be able to lower per unit costs and drive operating profit margin expansion over time.

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