Wal-Mart Shareholders Should Love A Jet.com Acquisition

Over the past eight years, the entirety of Wal-Mart’s (WMT) earnings growth has come from a combination of cost cuts and share buybacks. Wal-Mart made $13.5 billion in net profits back in 2008, and this year it is only expected to make around $13.3 billion profits. Despite making $200 million less in expected 2016 profits compared to the 2008 period, Wal-Mart shareholders have nevertheless experienced earnings per share growth from $3.42 to around $4.25 because Wal-Mart repurchased 800 million shares of its outstanding stock to bring the outstanding share count down from 3.9 billion to 3.1 billion.

It plowed around $56 of its retained cash flow, and even borrow a bit, to effect these buybacks. Sales at Wal-Mart haven’t grown since 2013, and so the mega-giant retailer has resorted to financial engineering to maintain its profit margins. Namely, it has adopted a bare-bones approach to hiring employees, perpetually understaffing checkout lines and relying more on the self-checkout lines to keep its employee costs low.

Wal-Mart has also resorted to a minimalist inventory approach where it has little ability to absorb unusual upticks in demand for its goods. Many Wal-Mart aisles routinely look like the Black Friday aftermath–this isn’t unusually high demand, but rather, the standard operating procedure for Wal-Mart’s inventory levels.

It is true that, so long as there is retained earnings earnings available to do so, buybacks can perpetually increase earnings per share and thus the value of each share over time.

However, there is something unsatisfying about a company that relies entirely on processing current sales figures a certain way to create shareholder value rather than selling more and more of its products to boost growth. Most of us know this intuitively, and if I had to guess why we all have this intuition, it would be that share repurchase growth inherently comes with a lower ceiling on potential returns than you’d see with a sales growth focused firm like Nike. The other concern is that financial engineering represents the final guard of protection for shareholder value creation, and a downtick in operating conditions can drop the intrinsic value in a hurry when cost-cutting and buybacks are no longer available.

If Sears grabbed the torch from Woolworth, and Wal-Mart grabbed it from Sears, then it follows that over the past fifteen years Amazon has been successfully executing its own heist for Wal-Mart’s claim on the best retail experience. Wal-Mart’s recent focus on share buybacks, lowest possible employee headcount, and inventory levels is not a customer-focused approach but a shareholder-focused approach.

The lower inventory levels in particular, as well as the lower employee headcount, act directly against providing an excellent customer experience. It may not be specifically quantifiable, but it is something that diminishes the Wal-Mart moat when decisions are made that inconvenience customers (this is especially stupid with the rise of e-commerce, as having a ready supply of items on hand that can be conveniently purchased at will is one of the few remaining advantages that brick-and-mortar stores have over their online competition).

With these circumstances in mind, I think that long-term Wal-Mart shareholders should welcome the news that the company is in talks to acquire jet.com. The early reaction from Wal-Mart shareholders has been negative towards the news because the rumor is that Wal-Mart may up to $3 billion to acquire the company which was just valued at a little over $1 billion in November.

Even acknowledging that complete control and ownership of a company demands a higher premium than the purchase of a minority interest, the critical shareholders do have a point that the purchase price may end up being excessive.

However, I still think this move should be welcomed in light of where Wal-Mart currently is and where it has recently been. For the past nine quarters, the sales growth at walmart.com has been nonexistent (1% growth here, 0.5% growth there). Wal-Mart has not been successful at developing its own e-commerce platform, and it makes sense that it should buy its way into the market (that is what Procter & Gamble had to do when it was struggling to expand its own household goods offerings, and ended up buying Gillette to gain a strong foothold in the market).

For the first time in at least a decade, this is a signal that Wal-Mart is going on the offensive to create shareholder value rather than relying on traditionally defensive metric to stimulate earnings per share growth.

There is also a strong synergy potential. Jet.com has a strong brand and is weaker on distribution, whereas Wal-Mart has extensive warehousing infrastructure but is not getting the amount of purchases on walmart.com that it would like. If Wal-Mart keeps the jet.com management in place, it could play a meaningful role in creating an alternative to Amazon. And as general public policy, it would be good for customers to have a meaningful alternative to Amazon (and Ebay’s focus on the used goods market doesn’t really make it a true competitive alternative).

Since at least 2008, Wal-Mart shareholders have witnessed their company focus on grinding out shareholder returns rather than grinding out ways to provide a superior customer experience. If a deal gets worked out to acquire jet.com, Wal-Mart shareholders should welcome this because it finally signals that Wal-Mart is aiming at taking moves to return to its roots by putting the customer first again, and it can also do so in a competitive way by investing in the only startup that has managed to steal a point of market share from Amazon. Overpayment is being identified as the primary risk here, but really, the greater risk for Wal-Mart shareholders over the long term is that they continue their recent focus on shareholders over customers until the point where their earnings power is irreparably harmed by a critical mass of fleeing customers.