Should I Buy Walmart? 3 Pros, 3 Cons

by Will Ashworth | August 15, 2013 3:26 pm

The world’s largest retailer reported disappointing second-quarter results this morning before the bell.

Walmart (WMT[1]) warned that customers are in both the U.S. and abroad are slowing their spending, so much so that same-store sales actually dropped here in the states last quarter.

Does today’s 3% drop make a good buying opportunity, or is more trouble around the corner? To decide, let’s take a look at the pros and cons.

Pros

Free Cash Flow: Any business worth its salt routinely grows free cash flow. Over the past decade, Walmart’s grown its overall free cash flow by 9% compounded annually, and on a per share basis, it’s closer to 13% thanks to stock buybacks. Critics will point out that WMT’s Q2 free cash flow actually declined year-over-year by 15%. However, almost $544 million of the difference was due to increased capital expenditures, while tax payments also played a role. And at the end of the day, Walmart has added $1.24 billion in cash and cash equivalents over the first six months of the year despite a tough business environment. With more than $9 billion in cash, it’s in a very strong financial position.

Sam’s Club: Walmart’s membership-only warehouse club seems to be forgotten in much chatter about the stock, but it delivered reasonable results in Q2. Same-store sales excluding fuel gained 1.7%, while operating income increased 8% year-over-year. Traffic at the stores continues to improve thanks to membership enhancements. Don’t write off Sam’s Club just yet.

International: On a constant currency basis, net sales increased 4.4% to $33.4 billion in Q2. And despite facing a severely challenging business environment, Walmart’s international business still managed to generate $1.47 billion in operating profit last quarter — only marginally lower than in the same quarter last year. Plus, international operating margins are lower than Walmart’s U.S. stores (not including Sam’s Club), so there’s significant room for improvement when it comes to profitability. It might not happen anytime soon, but it does provide a rosier picture of Walmart’s future potential.

Cons

Payroll Taxes: While it might seem insignificant, a 2 percentage point increase in payroll taxes reduces take-home pay for a family earning $50,000 annually by $1,000 or $83 per month. That means Walmart’s sweet spot is getting seriously hurt in the pocket book. There’s about 115 million households in America and I’d guess at least 60% are in Walmart’s target demographic. If each of those 69 million households spent $200 at Walmart and the rest on other family obligations, you’re talking about a revenue loss of almost $14 billion or 17% of its U.S. revenue. That isn’t immaterial.

Share Repurchases: I’m not a big fan of buybacks for the sole reason that most overpay. In the second quarter, Walmart repurchased $1.9 billion of its stock at an average price of $79.17 per share — $4 more than where it’s currently trading. In the last three fiscal years, it has repurchased $28.7 billion of its stock at an average price of $56.54 — a cumulative return on investment of 33%. That’s very good until you realize that it could have done virtually the same thing by investing in the SPDR S&P 500 (SPY[2]). Furthermore, its performance only looks so good because it bought more than half of the 507 million shares in fiscal 2011 when the markets were much lower. Even a blind squirrel gets an acorn now and again.

Costco: Every investment you make comes with a choice. In Walmart’s case, that option is Costco (COST[3]) — the tiny warehouse store from Seattle. Walmart’s free cash flow in the second quarter as a percentage of total assets was 2.6%, 240 basis points less than Costco’s most recent quarter. Same-store sales comparisons between the two discount retailers is non-starter. Costco’s kicking its butt. Plus, Costco’s demographic is older and wealthier — which is good for profits.

Verdict

The bottom line: Walmart has missed earnings estimates for five consecutive quarters. That shouldn’t give investors confidence. However, it’s still one of the best retailers in the world — big or small.

So should you buy Walmart’s stock? Given a choice, I’ll say no. Buy Costco instead.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.

Endnotes:

WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
COST: http://studio-5.financialcontent.com/investplace/quote?Symbol=COST

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