Tuesday, June 07, 2011

Should You Follow the Waltons into Wal-Mart?

The heirs of Sam Walton, Wal-Mart Stores (NYSE: WMT) founder, are about to own over 50% of its publicly traded shares. That still leaves some for you. Should you buy them?

Thanks to a $15 billion share buyback program, Walton's heirs will soon control just over 50% of Wal-Mart stock. After Walton's 1992 death, his family controlled 38% of the stock until the mid-2000s. But a series of big stock buyback programs beginning in 2003 push the heirs' stake higher -- to 43% in 2008, 49% in June 2011; and soon to top 50%.

But owning Wal-Mart stock divides into different eras -- the Thrill Years and the Boring Years. During the Thrill Years, Wal-Mart was a great stock to own -- from its 1978 initial public offering at a split-adjusted $0.08, Wal-Mart rose to $67 in December 1999, growing at a compound annual rate of 37.8% -- five times the rate of the average stock. Since the dawn of the 21st century, the Boring Years, the stock has fallen about 20% and -- with the exception of a nice run-up in 2007 -- gone nowhere. 

In the last decade, Wal-Mart has gotten much bigger but its stock has not followed suit. For example Wal-Mart sales and profits have grown 105% and 141%, respectively to $419 billion and $15.4 billion. Yet in the last decade, Wal-Mart's market capitalization has fallen 15% from $221 billion to $187 billion as the number of shares outstanding has declined 22% from 4.5 billion to 3.5 billion.

Why is the market not thrilled with Wal-Mart's financial performance? It could be that Wal-Mart has hit the limit of rapid growth that's imposed by a company reaching a certain size. For example, in order for Wal-Mart to grow at 15% a year, it would need to add $63 billion in sales in the next year -- that is like creating a new PepsiCo (NYSE: PEP) -- that booked $60 billion in 2010 sales -- every year. But for the last five years, Wal-Mart has been growing sales and profits at a 6% annual rate.

The difficult reality is that Wal-Mart cannot grow much faster. In theory, there should be enormous growth opportunities in large, developing nations that are growing much faster than the U.S. But Wal-Mart has not been able to penetrate these markets sufficiently -- it does have 338 shops in 124 Chinese cities, with 90,000 employees and annual sales of $7 billion. But that's less than 3% of its U.S. sales, according to The Economist.  And it is struggling to get a joint venture with India's Bharti -- India (population 1.1 billion) prohibits non-Indian companies from operating store fronts -- off the ground.

The second problem Wal-Mart faces is that its capabilities limit its ability to grow. This was not always the case. As I wrote in my book, Value Leadership, in the 1990s, Wal-Mart was able to use its skills to expand from discount retailing into pharmacies and grocery retailing. That's because its skills at keeping each stores' shelves stocked with items that customers wanted to buy and using its scale to negotiate volume discounts were directly applicable to building winning positions in new industries.

But when it came to expanding globally, Wal-Mart's performance was irregular. It failed in Germany but had more luck in Mexico with Wal-mart de Mexico (PINK: WMMVY). And then there's been the growth in e-commerce -- a development that was naturally difficult for Wal-Mart to exploit since management was more concerned about cannibalizing its stores than outcompeting the likes of Amazon (NASDAQ:AMZN) in delivering consumer e-commerce service. The result is that Wal-Mart's e-commerce sales are tiny -- it has not disclosed them recently but they may be about $2 billion.

Wal-Mart's first quarter performance reflects its now-plodding nature. On May 17, Wal-Mart reported a 4.4% revenue hike to $103.4 and a 3% rise in net income due to strong international sales -- that account for 26% of the total -- and tighter cost controls. But its same-store sales fell for the eighth straight quarter. It earned $3.39 billion, or 97 cents per share for the quarter ending April 30 -- beating analysts' expectations by 2 cents. That was better than 2010's first quarter earnings of $3.3 billion, or 87 cents per share.

Does Wal-Mart's ability to beat these modest expectations mean it's time to buy its stock? To think about that, we can look at their price-to-earnings-to-growth (PEG) ratio — a way to determine whether the value that the market assigns a stock is justified by the rate at which it expects the company’s earnings to grow. I think a PEG of 1.0 is a fair price, and anything below that is a bargain.

Wal-Mart's PEG of 1.27 is a little pricey. It trades at a P/E of 12.53 on earning forecast to grow 9.9% to $4.90 in 2012. But it has been growing at about a third of the rate in the most recent quarter with economic headwinds slowing down growth in the U.S.

Despite recent good news on international growth, I don't see that as a sufficient catalyst to drive up its stock price.


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