This Wide-Moat Retailer's Strengths Persist Despite Headwinds

Though wide-moat  Wal-Mart (WMT) has faced several headwinds over the past few quarters, we think the firm has the scale and reputation to compete amid elevated competition, which is bound to exist in the multichannel retail environment of the future. Higher health-care costs, reductions to consumer food stamp benefits, weak income growth, confidence among lower-income consumers, and heightened competition have all challenged the firm recently. However, while we expect the latter two headwinds to persist going forward, gas prices have fallen, some cost pressures will dissipate, and Wal-Mart’s U.S. comparable-store sales increased 0.5% during the third quarter, so there is some room for optimism.

In the United States, Wal-Mart plans to develop multiformat store "ecosystems" that serve all trip types (stockups at Supercenters, basic food trips at Neighborhood Markets, and fill-in trips at conveniently located Express stores). It intends to strategically open new Neighborhood Market and Express 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. Under this strategy, 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 support its wide moat, which is driven by its price leadership.

We may increase our $80 fair value estimate to account for the time value of money, but given that management’s outlook is in line with our forecasts, we don’t expect a material change to our long-term assumptions. Wal-Mart’s shares have converged to our fair value over the year, and we now believe the market price better reflects the firm’s long-term prospects. We still believe that Wal-Mart has enough fight in it to compete against strong rivals such as  Amazon (AMZN) and  Costco (COST), and the firm could still drive operating margins higher if comp growth accelerates. That said, we believe shares would be most attractive at a greater margin of safety.

Making Progress With Small Formats and E-Commerce
We think Wal-Mart’s omnichannel strategy will be important for its moat defense. The firm is investing heavily in the growth of small formats and e-commerce; encouragingly, e-commerce sales also increased 21%, and management expects that e-commerce sales will grow by 25% to $12.5 billion for the full year, and Wal-Mart U.S. comps were supported by 5.5% growth at Neighborhood Market stores. We still think the firm has a ways to go build out its scale in these channels, but we think that it is much further along than most other retailers.

Although positive comp growth is encouraging, traffic growth remains negative in most markets and concepts. For example, U.S. comparable-store traffic was down 0.7%, while traffic declined 0.2%, 0.7%, 1.4%, 2.6%, and 8.9% in the U.K., Mexico, Canada, Brazil, and China, respectively. That said, we were encouraged to see traffic growth at Sam’s Club (up 0.2%), as we believe this banner has been under considerable pressure given strong competition from Costco and Amazon. We still believe that Sam’s Club’s unit growth prospects are more limited, and competition could intensify as Costco continues to grow over time, but we think comps could be stabilizing for now, and we think 0%-2% comp growth is achievable for the year.

Operating margin declined 20 basis points to 5.3%, as price cuts weighed on gross margin (down 10 basis points on a consolidated basis, excluding membership fees) and higher health-care costs, e-commerce investments, and initiatives related to Foreign Corrupt Practices Act dealings weighed on the cost structure. We believe that e-commerce investments will continue into next year, which could limit sales leverage, but we think that as other near-term cost pressures ease and Wal-Mart’s investments drive top-line growth, the company should be able to drive margins back to 6% over time.

Wal-Mart's strategy to improve international returns and drive comp growth at Sam's Club through merchandising is sound, 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 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.

Our Fair Value Estimate Is $80 per Share
Our fair value estimate implies a fiscal 2015 price/earnings ratio of 16, enterprise value/EBITDA ratio of 8, and free cash flow yield around 6%. We continue to forecast overall annual domestic comparable-store sales in the 1%-2% range (excluding changes in fuel prices) and about 2%-3% total square footage, which equates to roughly 3%-4% total revenue growth over the medium term. We forecast Wal-Mart to add around 37,000 square feet this year, at the midpoint of management's updated guidance of 35,000-39,000 square feet. Our capital expenditure estimate of $12.8 billion for 2015 is at the midpoint of management's recently updated guidance. Over the longer term, we project maintenance capital expenditures as percentage of sales to eventually move in line with our 2% input for depreciation expense as a portion of revenue.

We project operating margins to be roughly flat in fiscal 2015, as we expect weak near-term comp growth (due to price cuts, reductions to food stamp benefits, and weak overall spending), higher health-care costs, and e-commerce investments could limit leverage opportunities. That said, we expect operating margins to expand modestly over the longer term as the firm works to leverage its cost structure and generate 100 basis points of operating expense reductions over the next few years. We forecast operating margins to average around 6% over the next five years, slightly above the 5.6% operating margin generated in fiscal 2014 and the three-year historical average of 5.8%.

Low-Cost Advantage Yields Low-Price Advantage for Consumers
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 $475 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 Likely to Make Decisions to Reinforce Wide Economic Moat
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 behind reinforcing its EDLP proposition. The company's $6 billion in price cuts, which have helped to swing domestic comparable-store sales from negative to positive in more recent periods, is the most notable example.

McMillon has been with Wal-Mart for 22 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 the international business most recently. We don't expect that McMillon will pursue a strategy that is materially different from the one outlined at Wal-Mart's October 2013 meeting for the investment community; 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 are maintaining our Standard stewardship rating, although we intend to update our analysis if the firm announces subsequent changes to its strategy and capital-allocation policies.

The board consists of 16 directors, 12 of whom are independent. Senior management compensation is mostly driven 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.