8/17/2010
By Brian Sozzi, Research Analyst

The second quarter could have been quite a different tale for Wal-Mart (WMT) than the results put forth today.  The fact that Wal-Mart managed an in line quarter on the EPS line and combined that with a $0.05 guidance raise on the high-end of its previous FY11 forecast are straightforward reasons for the positive market reaction.  Why could it have been worse for the largest retailer in the world?  Gross margin and customer traffic are under pressure, among other factors.

If the second quarter suggests anything about Wal-Mart it's that in a sluggish sales environment, brought on by economic conditions and merchandise misfires, it's that there are levers at management's disposal to bring down operating expenses.  Unallocated corporate expenses declined 15.3% y/y in the quarter, while slow traffic at Wal-Mart U.S. allowed for the strong utilization of employee hour scheduling tools which obviously has positive expense implications.  In raising its FY11 EPS guidance, Wal-Mart has signaled to the market that although sales will take time to gain momentum in the U.S., regardless of easier comparisons, it can keep a lid on expenses.  Though the expense message was great to observe, it detracts from the fact that Wal-Mart has not done the lifting needed to retain aspirational shoppers gained in the throes of the recession.  As a result, this has left Wal-Mart exposed to a core lower income customer base that spends cautiously on paycheck week, and not necessarily at Wal-Mart (dollars stores instead).

I hold the view that Wal-Mart shares have value trip written all over them until there are signs customers are returning to the stores.  There were areas of the 2Q11 report that conjure up red flags, and ultimately may assume increased consideration in our analysis (perhaps a downgrade to a sell rating...) as the second half of the fiscal year unfolds.  They include:

* Consumers reacted with a collective yawn to Wal-Mart's bread and butter price rollbacks in June and July.  We believe consumers found stronger assortments in grocery and apparel from Target (TGT is running positive traffic), and surprisingly more attractive price points at traditional grocers.  Accordingly, it depicts a Wal-Mart merchandising strategy that requires tweaking in order to (1) regain a small portion of the vital aspirational consumer; and (2) retain core lower income customers.  Credit tender represented 15% of Wal-Mart U.S. sales, telling as to the customer base composition at this juncture.

* Inventory has increased faster than sales at Wal-Mart U.S.; may encourage greater markdowns in second half of the year.

* Discretionary merchandise categories, home, apparel, and entrainment, all comped negative.

* Sam's Club comps well underperformed those of BJ's Wholesale (BJ) and Costco (COST) for the three-month period.

Discussion

* Rather unexciting numbers: Wal-Mart reported total revenues of $103.7 billion (consensus: $105.4 billion) and EPS of $0.97 (consensus: $0.97).  EPS was near the upper-end of guidance of $0.93 to $0.98.  Sales and operating income growth slowed by segment relative to 1Q11.  Wal-Mart U.S. failed to drive operating expense leverage, a function of the impact of price rollbacks on gross margin.  Overall growth was supported by (1) international businesses; (2) operating expense discipline; and (3) share repurchases.

* Not so fun facts: comp store sales for quarter missed consensus forecasts; all segments reported slower sales and earnings growth; overall comps have declined in five consecutive quarters; gross margin short of consensus by 31 bps.

* Guidance: 3Q11 EPS of $0.87 to $0.91 (comp composition: U.S. -2.0% to +1.0% and Sam's Club flat to +2.0% ex. gasoline).  FY11 EPS $3.95 to $4.05 compared to $3.90 to $4.00 previously.

Brian Sozzi
Wall Street Strategies