After a year of 30% gains in the general market, it seems like Wal-Mart (WMT) has been written off by many investors. While the shares may not see the kind of double-digit gains you can get from the next tech start-up, they will provide a consistent source of cash and the company has one of the widest competitive advantages in the market. Only trading at a slight discount to fair value, the company is attractive on its consistency in earnings and margin and should continue to be a core defensive play.
- Retail leader with significant pricing power on peers and suppliers
- Strong history of returning cash to shareholders with power for sustainable growth
- Slightly undervalued even on conservative estimates of growth and a stable outlook with much less risk compared to the general market
Wal-Mart is the largest retailer in the world with a massive $475 billion in annual global sales. This means that the company is able to demand competitive discounts from suppliers and has been able to use that power to pass lower prices down to consumers. Wal-Mart is the retail price leader in food and general merchandise with a brand that seems almost unassailable.
There is a huge opportunity in the pharmacy segment as Wal-Mart gains shares of drug sales against smaller retailers like Rite Aid (RAD) and Walgreens (WAG). The company does not seem to have captured the market here as it has with groceries.
The company is also rolling out the smaller store format for express needs in the city centers. Because of the large footprint needed for supercenters, the company has historically been under-represented in urban areas. While the small-store format may help increase sales in high-density areas, it also presents a risk of lower operating margins.
Sales at Wal-Mart have grown at a fairly consistent rate of 3.3% over the last five years with operating expenses growing slightly faster at an annualized 3.6% pace. Recently, spending on e-commerce has increased which has hurt margins but should pay off in the future with a stronger digital presence. While expenses have grown slightly faster, the company has maintained an operating margin of 5.6% or higher over the last decade.
In fact, one of the key draws for investors is consistency in performance from the company. Return on assets has only varied slightly from 7.8% to 9.3% over the last ten years and most margins have only varied by a few percent.
The company has been returning cash to shareholders over the last several years and holding less on the balance sheet. As of the last quarter, Wal-Mart had $7.3 billion in cash against $41.8 billion in long-term debt. As with most mega-cap behemoths, a large amount of debt is not necessarily a worry for investors. The company covers the interest on debt with income 11.5 times its obligations and has a AA credit rating from Morningstar. The company’s ten-year bonds yield 3.3%, less than two-thirds of a percent more than riskless 10-year Treasury Bonds.
Free cash flow has come in consistently between $10 billion and $13 billion over the last four years, even as the company spends around $13 billion in capital investments. As more markets reach a maturity level, the company should see less capital spending and more free cash flow.
Dividends and Growth
The company has paid dividends on its shares since 1973 but did not pay more than a penny a share dividend until 1991. The dividend has been increased for 39 consecutive years, putting it firmly within the Dividend Aristocrats.
The per share amount has been increased by an annualized 13.9% over the last ten years on a combination of a higher payout and an aggressive share buyback program. The company pays out 39% of its income as dividends and the shares offer a 2.5% yield. Wal-Mart has progressively returned more cash to shareholders as its growth matures. The current yield and payout ratio are above the five-year averages of 2.3% on an average payout ratio of 28% over the period.
Wal-Mart bought back $6.7 billion in shares last year, more than 2.5% of the company and has averaged $8.5 billion in annual repurchases over the last five years. In total, the company returned $13.5 billion in cash to shareholders last year.
The shares are currently trading for 16.0 times trailing earnings, slightly above its five-year average of 14.3 times earnings but still below the industry average of 17.3 times. The higher price multiple seems largely a function of higher multiples across the market. While there is downside to a broader market selloff, the shares are a classic defensive play and should hold up well.
Analysts are looking for 3.9% earnings growth to $5.31 per share this year on 2.9% sales growth. Expectations do not seem overly optimistic and the company has one of the largest competitive advantages in the market. Sales should continue to grow on store expansion and as Wal-Mart incorporates other services into its model.
I have used fairly conservative estimates of 12.5% dividend growth over the next five years and 10% in the next five years. These, along with a 4% terminal growth estimate, are probably below the company’s ability but will help to arrive at a fair value. Debt accounts for 43% of the capital structure at a cost of 3.3% on the ten-year bonds.
A discount of 6% to fair value may not seem like a strong buy signal but investors should consider the consistency of growth and dividend payments. Above the discount to fair value, the shares should provide a reliable total return on future growth. The consistency in operating performance, combined with huge competitive advantages and strong cash returns to shareholders, could make shares a core part of your dividend portfolio.