It was widely-reported that Amazon (AMZN) had unseated Walmart (WMT) as the largest broad-based retailer by market capitalization a few weeks ago, and the latter’s second-quarter fiscal 2016 results, released August 18, spoke to the very real risks that the avalanche of social change is having on its business.
From what we can gather, Walmart is at the center of a political upheaval in America that is challenging its business model. The company has become the poster child for all of what many workers believe is unfair pay, and such a tainted perception, fair or not, will be difficult to overcome as the ranks of millennials swell and demand their definition of “a living wage” after suffering through a very painful Great Recession. We talked about the upward path of labor expenses before, and we don’t see a scenario where they will abate…at least not anytime soon.
On May 19, the US’ second-largest city Los Angeles announced that it will raise its minimum wage to $15 per hour over time, following the lead set by Seattle and San Francisco. The wave for social change isn’t just transitory, and from our perspective, the “minimum wage” revolution has staying power. We’re hearing that there is a “minimum wage arms race” across the state of California. According to some reports, pizza places adopting the new wage hikes have to charge as much as $30 for a pizza and eliminate lunch hours, only to see sales fall 25%.
The social avalanche for change and a higher minimum wage has not been an isolated event. Two years ago, dozens of New York fast food workers went on strike, and many believed that change wasn’t in the cards. But just last month, New York City raised “the minimum wage for fast-food workers to $15 an hour by the end of 2018.” Washington DC may be next in line for $15 per hour, and other major cities in the US may be next. With the social media waves overflowing with workers pushing for more and more, the ability of groups to exert pressure on organizations has reached a pinnacle in the history of time.
Change is accelerating with each passing day, and we think Walmart may be the biggest loser in the court of social opinion. For one, we doubt employees are happy with Walmart’s plans to ensure that current Walmart associates will earn at least $10 per hour by February 2016, when the minimum wage in some of the largest cities in the US is 50% higher. The company’s employees and their families are essentially its customers, too, and frankly, it may not have a choice but to sacrifice margins to retain share. Playing hardball may only result in lower sales, creating what we would describe to be a not-so-virtuous employee/customer relations cycle.
In the fiscal second-quarter release, comparable store sales at Walmart US weren’t bad at 1.5% growth in the period (as traffic represented a good chuck of the improvement), Neighborhood Market comps also advanced nicely, and even e-commerce sales increased 16% on a constant-currency basis. The company, however, cut its 2015 earnings per share guidance to a range of $4.40-$4.70, from a previous range of $4.70-$5.05, blaming lower margins at Walmart US and investments in improving the customer experience. The retailer has been aware of currency headwinds for some time, so the revision is a rather large one and mostly fundamental, in our view.
Walmart’s consolidated operating income declined 10% in the fiscal second quarter (-7.2% excluding currency), and continued investments in store associate wages may make comparisons even worse in coming periods. Free cash flow has dropped to $5.1 billion in the six months ending July 31 (cash flow from operations of $10.1 billion less total capex of $5 billion) from $6.8 billion in the year-ago period ($11.9 billion in cash flow from operations less total capex of $5.1 billion). Fundamentals have and are deteriorating at the big box giant.
We want to be able to tell you that everything will be “okay” at Walmart, that it will improve the customer experience, that it will revitalize employee relations, that it will overcome changing consumer behavior and e-commerce proliferation at Amazon, eBay (EBAY), other e-commerce websites. But we don’t think it will, at least not anytime soon. We also wish we could tell you that shares of Walmart are cheap now that they have fallen from ~$90 per share in early 2015 to under $70 today. But they’re not. Fundamental challenges have become structural ones with new wage legislation across the US, and we expect shares to continue to face pressure.
The company has only cut through our fair value estimate today. The low end of our fair value range is a long way off.
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