Blue Light Special on Wal-Mart's Stock

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By David Trainer :

If you are look­ing for a good, safe stock in this volatile mar­ket, Wal-Mart ( WMT ) is one of the best. After strong gains in the 1980s and 1990s, Wal-Mart's stock price is lower now than it was in Octo­ber 1999.

The stock has gone nowhere in the last decade while rev­enues have grown 9% com­pounded annu­ally and after-tax cash flow ((NOPAT)) has grown 10% com­pounded annu­ally since 2000.

Com­ing into the last decade, Wal-Mart's busi­ness needed to grow into its stock price. Fig­ure 1 shows how, until 2009, Wal-Mart's stock price was well above its eco­nomic book value , which equals the value of Wal-Mart's exist­ing cash flows. The basic for­mula (more details here ) for eco­nomic book value is NOPAT divided by the firm's weighted aver­age cost of cap­i­tal (( WACC )).

I think of the eco­nomic book value as the no-growth value of the busi­ness or the value of the busi­ness if exist­ing prof­its stay flat for­ever. WMT's eco­nomic book value is $82 per share today. Its cur­rent stock price of ~$52 per share implies a per­ma­nent 35% decline in the company's profits.

Fig­ure 1: Stock Trades At Steep Dis­count to Eco­nomic Book Value


(Click to enlarge)

Sources: New Con­structs, LLC and com­pany filings

For most of the first decade of this cen­tury, I con­sid­ered Wal-Mart a good com­pany, but not a good stock. Not anymore.

Now that the stock trades at a 35% dis­count to its no-growth value, WMT is both a good com­pany and a good stock.

Even if Wal-Mart may be approach­ing its max­i­mum size, I think the worst-case sce­nario is that WMT's prof­its plateau, which, per above, implies a stock price of $82/share.

I believe prof­its will not drop off a cliff as the mar­ket sug­gests because Wal-Mart's man­age­ment has proven to be excel­lent cap­i­tal allo­ca­tors. Indeed, over the years, there has been lit­tle doubt about the qual­ity of Wal-Mart man­age­ment or the effi­ciency of its operations.

Lately, growth con­cerns have weighed on the stock. As Wal-Mart's growth decel­er­ated, it became a less pop­u­lar stock in a mar­ket that all-too-often seems obsessed with growth at all costs.

The momen­tum investors that seem to dom­i­nate the mar­ket these days do not appre­ci­ate or under­stand the value in Wal-Mart's busi­ness now that it is no longer a "growth story". In their obses­sion with growth, these investors tend to over­hype stocks on the upside and overkill on the down­side with lit­tle regard to the under­ly­ing eco­nom­ics of businesses.

They miss the fact that Wal-Mart gen­er­ates huge prof­its with rel­a­tively lit­tle growth because of its large size.

They also miss the fact that Wal-Mart's busi­ness has been a remark­ably steady per­former in tur­bu­lent times that have derailed many lesser companies.

Even while grow­ing NOPAT at 10% per year, Wal-Mart's return on invested cap­i­tal (( ROIC )) has remained admirably steady. See Fig­ure 2. Most com­pa­nies that grow as much and as steadily suf­fer steep declines in ROIC as they deploy large amounts of cap­i­tal with only hopes of future profits.

Not Wal-Mart, its ROIC has held steady as man­age­ment has intel­li­gently invested in stores, busi­nesses and acqui­si­tions that have earned impres­sive returns. This achieve­ment puts Wal-Mart in rare company.

Over the past 5 years, Wal-Mart has had the second-least volatile ROIC of all Rus­sell 3000 com­pa­nies with returns greater than 10%, next to little-known National Bank­shares ( NKSH ), which gets our "attrac­tive" rating.

Fig­ure 2: A Drop In Prof­its Would Be a Major Aberration


(Click to enlarge)

Sources: New Con­structs, LLC and com­pany filings

As is often the case in equity mar­kets, stocks over­shoot to the upside and to the down­side. WMT is an excellent exam­ple of a stock whose val­u­a­tion had over­shot to the upside when sen­ti­ment was pos­i­tive. Now, it is an exam­ple of a stock that has over­shot to the down­side as sen­ti­ment has turned decid­edly neg­a­tive. You know the script: the more exu­ber­ant the pos­i­tive sen­ti­ment, the more ruth­less the neg­a­tive sentiment.

This excess neg­a­tive sen­ti­ment pro­vides investors an excel­lent oppor­tu­nity to buy a great busi­ness at a great price.

Though WMT's growth is decel­er­at­ing and may decline, it is not likely that the com­pany will incur a per­ma­nent 35% reduc­tion in prof­its as implied by the market's cur­rent val­u­a­tion of the stock. Accord­ingly, down­side risk to the stock is low.

Upside reward poten­tial is strong as the stock has to go over $82/share to trade at a value that implies the company's prof­its will expe­ri­ence a 0% decline, a no-growth sce­nario. If the com­pany does any­thing bet­ter than a 35% decline in prof­its, the stock has upside.

I also rec­om­mend the fol­low­ing ETFs because of their "attrac­tive" rat­ing and expo­sure to WMT.

  1. Con­sumer Sta­ples Select Sec­tor SPDR ( XLP )
  2. Van­guard Con­sumer Sta­ples ETF - DNQ (VDC)
  3. Focus Morn­ingstar Con­sumer Defen­sive Index ETF (FCD)
  4. Pow­er­Shares Buy­back Achiev­ers (PKW)

Disclosure: I am long WMT.

See also LifePoint's CEO Discusses Q2 2011 Results - Earnings Call Transcript on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: NKSH , ROIC , WACC , WMT , XLP

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