When consumers think of retail, Walmart (WMT) and Target (TGT) are probably two of the biggest companies that come to mind. After all, the two big box retail giants have taken the US by storm throughout much of the 1990s and 2000s. But the shift to e-commerce with the proliferation of Amazon (AMZN) and eBay (EBAY) coupled with broad-based consumer backlash with respect to worker wages and credit card breaches, respectively, have created a whirlwind of negative public perception at the two giants as of late. Will worker unrest and Target’s failed attempt to expand beyond the borders of the US mark the generational stock price peaks at the two giants, respectively? Are both past their prime? The likelihood of ongoing disappoinments has increased, and neither registers high up on our watch list.
As we’ve outlined many a time before (see here, for example), 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 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. Cities in America continue to succumb to the “Fight for 15” phenomenon, and Walmart has the most to lose in the court of public opinion.
The biggest concern among the fearful is that, if the $15 per-hour mark becomes the lowest legally allowable pay, the ranks of workers receiving that pay would swell significantly (as more and more are aggregated at that level), creating a “worker party” in America like no other in the history of time. Could the voting power of such a party then work to absorb the majority of profits at service-oriented businesses by demanding more and more from the largest publicly-traded entities, Walmart and Target included? The long-term possibility is there, and given the expected growing strength of social media in coming decades, the concept becomes more probable than not.
In the third quarter of fiscal 2016, ended October 31, Walmart reported total revenue falling more than 1% from the year-ago period to $117.4 billion; excluding the impact of foreign exchange, total revenue grew 2.8%. In the US, the firm grew comparable store sales 1.5%, driven by traffic growth of 1.7% on a year-over-year basis. The company’s Neighborhood Markets–Walmart’s answer to the consumer’s desire for smaller, more convenient shopping centers–produced strong comparable sales growth of 8% in the period. The company’s General Merchandise department was the only department to report falling comparable sales in the third quarter.
Performance in Walmart’s primary international growth targets, China and Brazil, left a great deal to be desired in the third quarter. Though the China segment reported net sales growth of nearly 3% from the year-ago period due to new store expansions, a nearly 7% drop in traffic was partially offset by average ticket price increasing 6.2%, driving comparable sales down by 0.7% in the country. In Brazil, net sales fell by less than half of a percent on a year-over-year basis, and comparable sales fell 0.6% due to a more-than-3% drop in traffic being nearly offset by average ticket price gains. The economies of China and Brazil have not fared well lately, and the material drops in traffic in the period are not a good sign for Walmart in these regions.
Also negatively impacting Walmart’s results was its bulk food selling subsidiary Sam’s Club, where sales fell 2.2% on a year-over-year basis. Excluding the impact of fuel sales, the division’s sales grew 1.6%. Sam’s Club sales make up just over 12% of total Walmart sales. Though many point to the consistency of Costco’s (COST) performance, even the wholesale giant posted a decline in comparable sales in both the 4-week and 9-week periods, ended November 1, on a total company reported basis. If we back out the negative impacts from “gasoline price deflation and foreign exchange,” however, performance looked better in the periods, up 5% and 7%, respectively. Many have called for Walmart to spin off Sam’s Club in the past to give another management team better autonomy, and the probability of such an event has only increased, in our view.
Subpar top-line performance hurt Walmart’s operating income nearly 9% on a year-over-year basis in the quarter. Operating expenses grew nearly 120 basis points as a percent of total revenue due to increased store wages and hours and store restructuring, and we view cost pressures as perhaps the biggest threat to the retail superstore’s financial health. The impacts of the wage movement are no doubt being felt on Walmart’s bottom line, as diluted earnings per share from continuing operations fell more than 10% from the year-ago period to $1.03 in the third quarter.
The weak earnings at Walmart passed through to free cash flow generation, which fell by more than 6% through the first three quarters of the fiscal year, to $6.8 billion. The company now has a cash and cash equivalent position of nearly $7 billion on its balance sheet, compared to a total debt position of ~$52.5 billion. Though this is not the kind of balance sheet strength we’d like to see, the company’s Dividend Cushion ratio of 1.3 and dividend safety rating of GOOD suggests it has ample free cash flow generation to handle its debt load, assuming cost pressures don’t get completely out of control in the coming years.
For the full fiscal year, Walmart reduced its earnings-per-share guidance to a range of $4.50-$4.65, compared to original guidance of $4.40-$4.70 per share; earnings per share came in at $4.99 in fiscal 2015. The earnings pressure was expected in light of Walmart’s plans to invest heavily in its people and store experience. Sales growth is expected to be flat-to-up-3% for the year, while comparable sales growth is expected to come in at approximately 1%. Meager sales growth is to be somewhat expected from a company the size of Walmart, but the impact of a changing cost structure will likely be the difference-maker moving forward for Walmart.
Walmart is not alone in its challenges. Target also experienced relatively meager top-line growth in the third quarter of fiscal 2016, ended October 31. The company reported sales growth of just over 2% on a year-over-year basis to $17.6 billion, driven mostly by comparable sales growth of nearly 2%, which was primarily driven by traffic expansion of 1.4%. The quarter marks the fourth consecutive quarter the company has experienced positive traffic growth, the cornerstone of Target’s growth strategy for the foreseeable future, or perhaps what’s left of it. The company’s credit card blunder, though not entirely its fault, has left US consumers sore, and Target’s failed attempt at expanding into Canada (EWC) has left investors feeling the same.
Quite simply, if the company cannot expand into the US’ friendly neighbor to the north, which seems like a natural extension given the proximity and similarities between Canadian and American consumers, where else can it turn to grow, at least from a geographical standpoint? We’re not saying that Canadian and American cultures are exactly the same; we’re saying that they’re not that different, at least relative to the rest of the world, for example. After all, the countries share the same Stanley Cup championship and World Series playoffs… during the Normandy invasions of June 1944, the US stormed the beaches of Omaha and Utah, while Canada stormed Juno — there’s far more similarities than differences between the US and Canada, in our view.
Following this blunder, Target’s management has been refocusing its efforts to drive traffic growth through disciplined execution in its core operations in the US, succumbing to what we would consider short-term thinking. A long-term strategy should entail geographic expansion outside of the US. In any case, part of the refocus to drive traffic in its US stores has been the divestiture of its pharmacy business to CVS Health (CVS). Management believes that allowing CVS to operate its pharmacies under the CVS brand in a store-within-a-store format will bring in customers that may not have made Target a primary shopping destination. The companies are still attempting to clear regulatory hurdles in order to close the deal, but it’s starting to look like CVS got the best from the deal. Walgreens (WBA) is looking to wrap up its deal with Rite Aid (RAD) soon, further strengthening the competitive landscape.
Target’s improved focus is designed to benefit it most where Walmart is hurting, in its cost controls. Though it cannot change the political risk associated with the threat of increased minimum wage across many of its markets, it can materially impact other areas of its cost structure. In the third quarter, the firms selling, general, and administrative (SG&A) expenses fell as a percentage of revenue, a feat that was lost on Walmart. This helped Target grow its EBIT (operating income) by approximately 5% to $962 million, which helped push adjusted earnings per share up 8.6% form the year-ago period to $0.86; material share buybacks thus far in fiscal 2016 has boosted this number as well. Also benefitting margins was the firm’s digital channel sales, which grew 20% in the third quarter and added 40 basis points of improvement to its comparable sales growth on a year-over-year basis. By comparison, Walmart’s e-commerce sales expanded 10% in the period.
Target grew its free cash flow during the first three quarters of 2015 by a material amount; $2.6 billion in free cash flow was nearly three times the amount it generated during the same period in 2014. This was driven by cash from operations nearly doubling, which was boosted by a more than $1.3 billion positive swing in cash from discontinued operations from the year-ago period. Slightly lower capital expenditures also provided some benefit to free cash flow generation, a reflection of the new disciplined spending strategy Target looks to employ moving forward. Long-term holders of Target’s equity may want the company to keep plowing growth capital back into the business, however.
The strong free cash flow generation in the period should have provided a material benefit to the firm’s cash position, but a rapid increase in the repurchasing of shares has taken nearly $2.2 billion cash through the first nine months of fiscal 2016. This drove Target’s cash balance to shrink to just under $2 billion, compared to total debt of $12.8 billion. We expect the firm’s free cash flow generation to be significant enough to handle this debt load, however. Its Dividend Cushion ratio is a healthy 1.8, and we see no reason why Target cannot continue to pay a growing dividend as it has for more than the past decade.
Following the third quarter of its fiscal 2016, Target slightly raised its guidance range for adjusted earnings per share to $4.65-$4.75 from $4.60-$4.75, a stark difference from the trajectory of earnings at rival Walmart. Investors were generally pleased with this, especially when considering the fact that many other retailers had issued weaker-than-expected guidance heading into the holiday season. Arguably, the group that has been hurt the most thus far into 2015 has been the department stores. Have a look.
All things considered, there was nothing surprising in Walmart’s or Target’s third-quarter report, at least from the story lines we’ve been outlining. Both continue to expect modest growth in their top-lines, but several concerns keep us and many long-term-oriented investors on the sidelines. First, we can’t get comfortable with the long-term implications surrounding Walmart’s cost structure, and Target’s blunder in Canada, albeit a retracted one, may be a foreshadowing of what could take place in future geographic growth opportunities, should they be pursued. The issues stemming from Target’s credit card data breach may finally be subsiding, but the public has a tendency of not forgetting such events easily. Investor confidence may remain shaken for some time.
Despite all that has gone on around these two broad-based retail behemoths and the material drop in share prices that both have experienced in 2015, we cannot say that either is significantly undervalued based on our fair value estimate ranges, as shown in their 16-page valuation reports. The dividends of either company may offer some reasonable income in the near term–both yields are shy of 3%–with safety coming from the scale of the business operations and substantial free cash flow generation (as opposed to innate balance sheet flexibility), but without their trading at a substantial discount to our estimate of their respective intrinsic values, it’s hard for us to pull the trigger on either.