Image Source: Steven Depolo
It’s not the roaring 1990s anymore, investors!
There are serious risks to the business models of Target (TGT) and Walmart (WMT), and everyone is looking the other way, consoling themselves with their steady and growing stream of dividends. These investors say, “as long as they pay the dividend, I don’t care,” as if this signals a proud achievement in some way, by which many experienced market participants will then respond, “and now we know why the individual investor is frequently blindsided.”
The dividend is a symptom of the health of free cash flow, and management teams can dip into the balance sheet to support the payout. Only trends in free cash flow generation, supported by moaty business models, speak to the strength of a company’s underlying fundamentals – this is not a matter of opinion, but a matter of fact. Business owners all over the world know that cash flow is their most important asset—not what they pay out as a distribution in any given year. Shareholders are business owners.
Like a master magician, executive teams draw the attention of the investors to a source of distraction (an increasing dividend) away from the chosen object of analysis worthy of attention (the business and future free cash flows). The causes of a distraction are varied: “the lack of ability to pay attention; lack of interest in the object of attention, or the great intensity, novelty or attractiveness of something other than the object of attention.” Are you attracted only by the dividend? Then, the master magicians in the executive suite are having their way with you. It’s the card up their sleeve. The dividend is just one of many important things, and you should know this by now.
Let’s get to Target and Walmart, both entities reporting results earlier this week.
First, there is one reason that we are vitally concerned with the long-term picture at Target, and we’ll talk about this in depth. Second, there are two reasons why we think Walmart’s long-term picture is bleak, albeit both of the factors at Walmart arguably apply to Target’s business model, too. Now, don’t get us wrong. Let’s be clear. Are Target and Walmart fantastic free cash flow generators? Absolutely. Do Target and Walmart have substantial competitive advantages? Absolutely. Will Target and Walmart continue to pay their dividends for the foreseeable future? Absolutely.
These aren’t the points we are addressing. Every business will have strengths and weaknesses, and in this piece, we’d like to address the ones most prevalent on our minds – both for brevity and relevancy. Target’s and Walmart’s 16-page stock reports and the commentary archives on them can be accessed on their respective landing pages. So, when we speak of concerns, we’re talking about fundamental dynamics, and how they may come back to impede future earnings and cash-flow performance, perhaps not in the next year or two, but in the next 5 to 10 years.
For those that may have missed the event, Target closed the last of its 133 retail stores in Canada April 12, laying off 17,000 employees and taking a $5.1 billion quarterly charge. The justification for leaving Canada boiled down to the following rather unusual short-term oriented statement: “Unfortunately, we were unable to find a realistic scenario that would get Target Canada to profitability until at least 2021.” Six years? Just six years? This is a blink-of-an-eye for most long-term investors. But yet, complete abandonment? We didn’t think the problems in Canada were unfixable. Inventory, pricing, and branding should be core competencies for any retailer. After all, there are successful retailers in Canada, and Target’s one of the best in the US. It should have worked. Right?
Here’s what you need to know – and here’s the real reason why Target abandoned Canada. At the beginning of 2014, the incentive committee at Target added ROIC as a third metric to its performance stock unit plan (measured through 2017). According to the new incentive plan, the Canadian Segment would be “included in ROIC to ensure participants are held accountable for the significant startup investment related to this key growth initiative.” Brian Cornell joined Target as board chairman and the new CEO in August 2014. Did you really think the new head honcho was going to spend his first six years on the job languishing over building a business in Canada, while receiving no incentive pay for such efforts? We think not. Hence, the exit from Canada ensued, for good or bad.
From our perspective, however, by abandoning Canada, Target has effectively capped the size of its company. As perhaps many of our Canadian friends would agree, the US and Canada aren’t too different. In fact, we can’t think of many differences at all. However, Target’s foray into Canada and its rapid abandonment of its efforts in the country reveal something terribly wrong with the transportability of its franchise–and an incentive structure at the top that’s still too near-term focused. We learned about the superiority of ROIC over operating EPS targets in incentive structures with respective to the example with IBM (IBM), but the length of the measurement period of an incentive plan is important as well. It’s very possible that a 10-year incentive program as it relates to Target’s Canadian business would have kept top brass in the game.
In 2021, we think Target investors will look back and say, “We could have had a profitable Canada by now.” It’s very probable, and we can’t wait to find out.
Let’s now move on to Walmart.
First, we won’t belabor this issue, but the well-documented view of encroaching online competition from Amazon (AMZN) and from dollar-store retailers such as Dollar General (DG) and Dollar Tree (DLTR) is only worth a brief mention, and we’ll now move on. ‘Nuff said, as you may say.
Second, Walmart is at the center of political upheaval in America. The company has become the poster child for all of what many believe is unfair pay practices, and this will be difficult to overcome as the ranks of millenials swell. We talked about the frightening path of labor expenses in this piece here, but they won’t abate…at least not anytime soon. We nearly fell out of our desk chairs when we heard the country’s second-largest city Los Angeles was raising its minimum wage to $15 per hour over time, following the lead set by Seattle. It didn’t just pass – the City Council voted 14-to-1 in favor!
With product prices under pressure and labor costs on the rise, something’s got to give. It really doesn’t take a mathematician to understand that Walmart is simply getting squeezed and may be in a lot of trouble over the long haul. As for the minimum wage hikes, we don’t know how workers will fare during the next recession, which is an inevitable part of the cycle, but when revenue falls and labor-costs-per-person have price floors, the only response is layoffs. Both Target and Walmart know it.
Could our social programs in raising wage floors be setting us up for one of the worst economic periods in history – the next recession? We’re not ruling it out, but that’s a topic for another day.