Wal-Mart Invests for the Future

Our long-term thesis--that Wal-Mart is among the better-positioned firms with an omnichannel approach--is unchanged. However, for the shares to completely converge toward our fair value estimate, the company will need to leverage its moderating investments, presumably over the next one to two years. Moving a ship the size of Wal-Mart takes time, and we caution against extrapolating one quarter (positive or negative) into the indefinite future.

In the near term, we still expect the company's investments to weigh on results, and first-quarter results confirmed these expectations. The operating margin contracted 30 basis points to 4.6% during the quarter, largely reflecting the second phase of Wal-Mart's wage increases. The hit to the first quarter should be the largest of the year, given that the firm implemented this year's increases in February (versus first-phase increases in April). Continued price cuts will offset the easing wage pressure.

There were some positives during the quarter. Most notably, same-store sales growth of 1% at Wal-Mart U.S. was greater than we expected, with traffic increasing 1.5% and average ticket declining 0.5%. Much of the decline was due to food price deflation (which detracted 60 basis points from the comp growth rate), but same-store sales increased by the midsingle digits in health and wellness and low single digits in general merchandise. These results represent the seventh consecutive quarter of positive same-store sales growth and the sixth consecutive quarter of positive traffic for Wal-Mart U.S., suggesting to us that despite all the justifiable concerns about competition, the Wal-Mart banner still has the power to drive traffic.

However, e-commerce sales grew just 7% (U.S. growth was higher but not disclosed), clearly below rates posted by larger rival Amazon AMZN and smaller competitor Target TGT. Accelerating e-commerce revenue, a critical component to our Wal-Mart thesis, still needs time to play out. Wal-Mart's e-commerce business is a tale of two stories, both of which need to come together over the long term. The first component is the capability to fulfill orders in a cost-competitive manner. With an established distribution network and e-commerce fulfillment centers near completion, the company is close to having a competitive e-commerce supply chain, in our view.

The second and more uncertain component is whether online investments will actually drive online sales growth. Our confidence in Wal-Mart's ability to drive e-commerce traffic stems from our view that convenience and price will remain key drivers of consumer shopping habits, and we think Wal-Mart has the potential to offer customers both of those. On the convenience side, we see Wal-Mart's strategy to deploy grocery click-and-collect as a key differentiator. Online grocery is still in its early innings, but it will be harder for e-commerce to penetrate than other categories. This gives Wal-Mart an opportunity to increase website visits; once consumers are on the website, Wal-Mart has the potential to push general merchandise in addition to grocery.

Wal-Mart is also piloting ShippingPass, which offers members free two-day shipping for an annual fee of $50. This service is aimed at competing more directly with Amazon, but Wal-Mart is not at a point to scale as of yet, in our opinion. We don't see ShippingPass denting Amazon Prime's growth trajectory, but we do think it can help Wal-Mart stem customer losses. While many retailers will lose share to Amazon in the coming years, we do think that more than one firm can succeed in the future.

We do not believe that e-commerce growth poses a material cannibalization threat to Wal-Mart, because online fulfillment centers increase Wal-Mart's product assortment to more than 10 million stock-keeping units (versus 150,000 in a supercenter). E-commerce fulfillment centers will also offer access to markets (such as New York) where the company does not have a store presence; these markets are complete greenspace for Wal-Mart, even if consumers don't want to shop in its stores.