I saw the recent news release that Wal-Mart is shaking up its top management positions in an effort to spur growth, with the latest strategy involving small neighborhood stores and more organic, healthy grocery items lining the front area of the store. With back-to-back dividend increases in the 2% range, people have been wondering what issues currently exist at Wal-Mart that are worthy of an investor’s examination. The deep issue is this: It is difficult for a company that generates $487 billion in annual sales to grow at a fast rate. Shareholder wealth creation largely consists of buybacks, dividends, and efficiencies at that point rather than robust top-line revenue growth.
My take on Wal-Mart’s problems are as follows:
One. The company achieved 10.5% annual earnings per share growth over the past ten years not because the company’s profits were growing at a furious rate but because the company was repurchasing very high amounts of stock. The share count declined from 4.2 billion to 3.2 billion. About one out of every four Wal-Mart shares got retired in the past decade, and that added a few percentage points to the earnings per share growth rate.
This is a valid way to create wealth but the problem is that the company is at the end of the line. It has $55 billion in debt because the company borrowed at low rates to conduct these share buybacks. Paying off the debt is manageable; the long-term interest over the course of paying off the $55 billion over the next twenty-five years will only be $2.4 billion, and the retailing giant generates profits of $16 billion per year. This correlates to item number two, the rise in Wal-Mart’s payout ratio.
Two. Back in 2003, 2004, and 2005, the dividend payments at Wal-Mart only ate up 22% of the company’s profits. This allowed Wal-Mart to retain a substantial amount of cash flow to open up new stores and buy back its own stock. Yes, it chose to borrow as well to do this, but the profits on hand were able to contribute substantially to growing future earnings per share. Right now, Wal-Mart’s dividend payout ratio is at 49%. Half of the company’s profits go towards paying the dividend, and this is difficult when you also need a substantial stock repurchase program to reduce the share count to raise earnings per share because the company will likely grow in the mid-single digits over the long term.
Three. The company tests the limits of keeping the fewest number of employees on hand to run the stores. It is an understandable dilemma. There are 2,200,000 Wal-Mart employees in the world. If the company wanted fully staffed stores and increased the work force by 10%, the company would have to pay $5.9 billion (220,000 employees earning $27,000 per year) so the company’s profits would be cut from the $16 billion range to the $10 billion range. This isn’t like Cohen & Steers where you have 200 guys running a $2 billion empire; changes in the head count policy at each store has an outsized effect because there are 11,400 stores.
Even though I understand this dilemma, people tend to grow patient with long wait times and will shop elsewhere rather than wait ten, fifteen, twenty minutes to make a purchase. Wal-Mart has combated this by creating self-checkout lanes that run most of the day (if not the entire day in some locations), but this has been something that mitigates the issue rather than solves the issue because people that do serious shopping (20+ items with $200+ bills) still have to wait a long time. It’s a heck of a business model when you make the people paying you the most amount of money wait the longest.
Four. Wal-Mart has chosen to cut costs by keeping low amounts of inventory on hand. That is why when you visit Wal-Mart you will often see vacant aisles that look reminiscent of stores after a grand opening (or the cynical metaphor would be to compare it to K-Mart after its bankruptcy sales). Wal-Mart wants to minimize the number of items sitting in the back of the stores waiting to be displayed to customers, and the effect of this is that unusual one-time purchases affect the supply chain. If you whimsically go to Wal-Mart and buy 20 boxes of Lindt chocolate, it is not going to be able to serve future customers Lindt chocolate for a week or two. This approach tends to frustrate customers, especially because it is happening with higher frequency.
Despite all of these concerns, I do think it is more likely than not that Wal-Mart will deliver satisfactory returns to investors going forward. It will probably grow 4-6% in the long-term, buy back 2-3% of its stock, and you get a 2.4% dividend. That means people buying Wal-Mart at $81 per share today will likely experience future returns somewhere between 8.4% and 11.4%. Wal-Mart has more problems with store management and organic growth than has historically been the case, but it should still perform in a range that is within a point or two of an S&P 500 Index over the coming decade or so.