2/16/2010
By Brian Sozzi, Research Analyst

On February 18, Wal-Mart Stores Inc.'s (WMT) long-awaited holiday quarter earnings report arrives to hungry investors.  The report reminds us of that leftover gift found behind the Christmas tree upon cleanup; the holiday season is gone, but a distant memory, though that one reminder takes us back.  Let's rehash what's already known:

* The holiday season in the U.S. surpassed cautious expectations; consumers felt less afraid with respect to their financial positions and spent more freely.  Not only was this confirmed by the holiday chain store sales reports but also within consumer data from the government and statements from credit card companies.
* Pricing was very competitive (led of course by Wal-Mart) but not as much as 2008.
* The U.S. dollar was weak, thus likely benefiting Wal-Mart's international sales.  For perspective, glance at the recent monthly sales reports from Costco Wholesale (COST).
* Food deflation was apparent, with moderation as the quarter progressed.

We believe that despite all the headwinds that existed during the holidays, it's telling that Wal-Mart management did not feel the need to revise its 4Q EPS guidance of $1.08-$1.12.  The company had every opportunity to comment on its outlook upon announcing its decision to trim expenses at Sam's Club and striking a deal with sourcing giant Li & Fung.  Yet, not a peep from the management team that earnings could disappointment.  Our modeling has Wal-Mart posting 4Q EPS of $1.13 (on the easiest earnings comparison of the fiscal year) and eclipsing its own outlook that was deemed "disappointing" when 3Q earnings were announced in November.

Guidance for 1Q11 and FY11, as no surprise, will be of pivotal importance.  Our sense is that Wal-Mart, trying to assuage fears that as the consumer becomes increasingly confident they will bypass Wal-Mart supercenters, could issue in line to slightly above consensus EPS guidance.  There are reasons to expect this cautiously optimistic stance, including:

1. The search for value by the consumer remains intact.  We believe that Wal-Mart's customer base has made conscious changes to how they spend.  In this type of external environment, Wal-Mart thrives.  Looked at another way, even if the global economy goes on a period of trend GDP growth, Wal-Mart wins as it has upgraded its assortments considerably in home electronics, fresh food, mobile phones, apparel, and home.
2. Absent major inflation or deflation in 2010, Wal-Mart thrives as it's able to lower prices but boost margins through economies of scale.
3. Costs pulled from the operating model in 2009 feed through in 2010.
4. Focus on capex and inventory containment likely to remain.

That said, we believe there is a need for investors to view Wal-Mart's business in a longer term context.  Presently valued at a PE multiple of a mere 13.3x estimated calendar 2010 EPS (49% discount to 10-year average), 6.2x estimated calendar 2010 EBITDA (48% discount to 10-year average), and 0.47x estimated calendar 2010 sales (47% discount to 10-year average), is there anything on the five-year horizon that would suggest these levels of valuation are not a trough?  Unionization of Wal-Mart's employees is a risk that has been out there for some time, but there are no clear signs that a union if forthcoming.  Are consumers just kidding themselves that they are all for deals?  Assuming even a modest trade up along the merchandise curve, Wal-Mart again, doesn't strike us at risk of ceding a material degree of market share.  Is the U.S. on a path to 1980s style inflation that cripples Wal-Mart's low price business model?  It's a relevant debate to have, but inflation of that magnitude does not appear to be on the horizon in 2010 or 2011 barring a shock to the oil markets.

In other words, the case could easily be made that Wal-Mart can boost its forward growth rates in sales and earnings above present market expectations, thus warranting a higher valuation.  The company could do this by (1) opening smaller, high ROI urban stores, (2) further expanding square footage internationally and improving upon how the mix of businesses are operated, and (3) altering fundamentally the cost structure.

It's number three on the list just outlined that we would like to momentarily expand.  As we have discussed with clients, it's our view that Wal-Mart is entering the next phase of its fundamental transformation.  The initial phase of the transformation perhaps began in late 2006 when Wal-Mart, pressed by the analyst community, decided to pare new U.S. store opening plans and its capex commitment.  Wal-Mart then followed this act up in 2007 with added plans to curtail new U.S. openings, reduce inventory, and pullback on capex.  The results have been nothing shy of impressive.  Wal-Mart's gross margin is holding north of 24.00% after years of ranging from 20.50%-23.00%.  Operating margin for the last seven quarters has averaged 5.64%; over a 15-year time horizon the business has posted operating margins from 5.37% to 6.06%, with most years around 5.40%-5.50%.  Through a multitude of initiatives quietly announced late last year and in 2010, there is strong possibility that Wal-Mart continues to attain new levels in gross margin while breaking 6.00% on an operating margin basis quicker than consensus anticipates (calendar 2011).

"Green" Initiatives
Many are not discussing this but they should be as its ranks up there in importance to a long-term thesis for Wal-Mart.  Wal-Mart's desire to press suppliers to print the amount of energy consumed to manufacture a particular product not only reinforces a "green" consumer message, but will lower supply chain costs.  If Campbell's Soup (CPB) were to use 30% less energy to produce a can of soup, for example, that would create bargaining leverage on the part of Wal-Mart's buying team.  Wal-Mart would essentially know that Campbell's has reduced costs, and in turn, would want a good portion of those cost savings passed onto them.   Energy efficient distribution centers in the U.S. and Canada, which use hydrogen cells in forklifts, LED lights, and solar panels is another "green" maneuver designed to bring down costs.

Sourcing
The deal with Li & Fung to consolidate a percentage of its sourcing, thus reducing costs, will provide Wal-Mart executives with valuable insight into how to improve overseas sourcing.  Importantly, it will lead to stronger margins for Wal-Mart's private label goods as it attempts to expand direct sourcing.

Final Note

In closing, it's Wal-Mart's constant strive to improve its already impressively efficient cost structure, while capitalizing on new segments of the U.S. and international retail landscapes, that gives us confidence that return metrics are pointing due north.  By extension, we reason that present valuation is attractive.  We reiterate our Buy rating on the stock.

Brian Sozzi
Wall Street Strategies