Walmart's E-Commerce Push Continues

Walmart’s growth opportunities aren’t confined to expanding distribution. Our 2.5% average 10-year top-line growth estimate assumes continued gains in the grocery segment (60% of total sales). This quarter’s results supported our thesis, with the category comping at a low-single-digit rate, similar to the prior four quarters. We expect this trajectory to persist, given Walmart’s 1,100 click-and-collect stores currently and 2,100 expected by year-end, versus its 4,700 total U.S. stores. These outlets are useful for traditional retailing but also could bolster e-commerce sales as they are used for pickup and fulfillment. We think these omnichannel efforts are aided by the 200 automated pickup towers in stores, which also validate Walmart’s existing physical units. As a result of its scale and reach, we think Walmart is poised for growth and should sustain its competitive edge against industry headwinds.

We think Walmart is correctly adjusting its capital-allocation strategy to compete. Its sale of Asda to Sainsbury (previously 5% of sales, although Walmart will retain a 42% stake in the combined entity) helps the company move away from the ultracompetitive U.K. market and protect its profitability. This segment has seen operating margins decline from over 4.5% in fiscal 2015 to under 3% today due to the competitive marketplace. The sale freed up $4 billion for Walmart’s pending purchase of 77% of Flipkart, a leading e-commerce player in the Indian market, for $16 billion. This purchase should help Walmart’s growth prospects, as Flipkart is increasing gross merchandise volume by 50% a year, with $4.9 billion in sales at the end of fiscal 2018. It also should afford Walmart better insights into the 1.3 billion-person Indian market, which should aid traffic and transaction growth.

Significant Bargaining Power We believe Walmart has a wide economic moat that comes from a cost advantage and intangible assets. As the largest retailer in the world with approximately $500 billion in annual revenue, Walmart has significant bargaining power as it procures merchandise from suppliers and vendors. As a result, it can offer its customers lower prices than many of its competitors. These superior economies of scale, paired with a dominant distribution network, should continue to drive per unit costs lower over time, creating a positive productivity loop to further prop up volume and prompt incremental market share gains. Nearly 60% of Walmart's sales are from highly perishable, high-turnover items, which should continue to drive foot traffic to its stores and ensure it benefits from a throughput cost advantage, with items turning 8 times a year, outpacing big-box rival Target's TGT 6. Walmart's efficiency is also evident in its approximate $430 in sales per square foot, which far exceeds Target's $290. Because Walmart dominates customers' mind share for low prices and value, we believe it has amassed considerable trust and brand equity with consumers, providing an intangible asset moat source. In combination, this edge has enabled Walmart to generate returns on invested capital of around 13% on average over the past five years, in excess of our 7% cost of capital estimate.

Despite low switching costs in retail, Walmart has been able to build a model that delivers much of what customers need: low prices, convenience, and a one-stop shop with a wide selection of products including grocery. A key aspect of Walmart’s dominance, aside from its existing store footprint and brand, is its national fulfillment and distribution network that blankets the entire United States. This network allows Walmart to better leverage its distribution costs and control its supply chain. The company also benefits from better inventory management, as closer proximity eliminates costly out-of-stocks and should allow for better efficiencies in shipping, with closer stores leading to lower marginal costs per basket. These advantages have yet to transfer to e-commerce for Walmart, given Amazon’s first-mover advantage. However, we believe Walmart is poised to be one of the few retailers that can compete in e-commerce and stay relevant over the next decade as its established physical footprint begins to bear fruit.

Competition Is Intense The largest risk for Walmart is the battle between e-commerce and its physical infrastructure and the degree to which it can generate profitable sales in this intensely competitive landscape. Walmart could also face increased competition from hard discounters like Aldi and Lidl, which are expanding in the U.S. Lidl opened its first store in June 2017 and anticipates another 500-700 over time, while Aldi already operates 1,600 stores in the U.S. and is pushing to open another 600 over the next few years. The increased presence of hard discounters could exacerbate any price competition Walmart presently faces and may pressure gross margins more than we currently forecast. However, we believe Walmart's merchandise mix and low cost structure would support the company should hard economic times hit; sales on an absolute basis could decline, but relative to other retailers, Walmart might actually benefit. Major competitors, namely Amazon, Costco COST, and Target, could take share from Walmart should the company fail to adequately invest in its business and stay in front of retailing trends. Current initiatives (including investing in technology and its e-commerce platform) appear favorable to its long-term competitive positioning, but execution risk could arise.

Given that it operates stores around the world, with about one fourth of its sales derived outside the U.S., Walmart is exposed to various other risks, including foreign currency movements, sovereign policy risk, and geopolitical considerations. In addition, we estimate 20%-30% of Walmart’s sales are from its private-label brands, exposing it to erratic changes in commodity costs; offsetting inflationary pressures with higher prices may constrain volume growth and traffic trends.

In terms of its priorities for cash, we anticipate Walmart will pay out around 40% of earnings to shareholders in the form of dividends. We believe the company will continue to raise its dividend at a mid-single-digit clip, directionally consistent with our earnings per share assumption. Further, we assume the company will repurchase 3% of shares outstanding annually. We expect Walmart will continue to make acquisitions like Jet.com, Moosejaw, and ShoeBuy, but given the uncertainty surrounding the timing and nature of potential deals, we do not include unannounced acquisitions in our discounted cash flow model.