Stock market analysis of Walmart

Wal-Mart was the brainchild of Sam Walton, an entrepreneur who owned a number of variety stores. Eventually he wanted to break out onto his own. The modern Wal-Mart was founded in 1962. Walton was a skilled merchandiser, and sought to drive traffic to his stores by being the lowest-cost seller in the area. This was critical because he initially operated in small towns that did not have larger competitors. He needed to entice shoppers to eschew the long drive to larger stores and low prices were the key. From there the chain quickly expanded. Even into the 1980s Wal-Mart remained a regional operation but the discount retailing industry enjoyed rapid growth through the 1990s (Wal-Mart.com, 2009). Wal-Mart did more than just ride the wave, it sold the surfboard. Wal-Mart today is the world's largest company, with a market cap of $194.2 billion (MSN Moneycentral, 2009). The firm operates in the discount retail sector, selling a wide range of consumer goods under the Wal-Mart and Sam's Club brands. The company is also active internationally, with major operations in Mexico, Canada, China and other nations.

3) One news item regarding Wal-Mart concerns the company's push into organic and natural foods. This move is generating consideration controversy for a number of reasons. One is that it is expected to drive down prices of organic foods, reducing margins for producers. It is felt that Wal-Mart would fight to lower organic labeling standards, and would being to import organic produce from China in order to compete with U.S.-farmed product (Gogoi, 2006).

Another news item concerning Wal-Mart is with respect to its profitability. The company is faring very well this economic downturn, a function of its low-cost strategy. The firm recorded profit figures above expectations and is gaining market share at the expense of its competitors. The company's same store sales are continuing to improve. The firm has adopted a short-term strategy of retaining the new customers that they have acquired as a result of the downturn (Rosenbloom, 2009).

4) Wal-Mart has superior profitability ratios compared with rival Target. On the surface, Target's higher gross margin would appear to be a strength, but it is in fact a weakness. When you drill down, the superior gross margin translate to a marginally superior operating margin. The two firms have the same net margin. This means that Wal-Mart is the more efficient of the two companies, and has the lower cost structure.

The lower cost structure gives Wal-Mart a competitive advantage over Target. In the discount retailing business, being the lowest-price competitor is a source of sustainable competitive advantage. Therefore, because Wal-Mart takes a lower gross margin than does Target, they will be able to entice more customers because they will be able to offer lower prices. From these lower prices, Wal-Mart is still able to extract the same amount of profit as Target.

Wal-Mart's margins nevertheless compare well with those of the industry as a whole (the probably impact of giant Wal-Mart on the industry averages should not be overlooked here, though). The company uses its exceptional cost control to not earn the same profits as its competitors while simultaneously offering lower costs, a sustainable competitive advantage in particular over Target.

5) Wal-Mart has strong asset utilization ratios. The standout number here is the receivables turnover. Wal-Mart is known for being a tough customer in its dealings, and its approach to the credit card companies is no exception. Wal-Mart drives home a receivables turnover of 106 times, or an average collection period of just over 3 days. Wal-Marts receivables figure is close to the industry average, only a little bit higher than that of Costco. For whatever reason, Target dramatically underperforms, having higher receivables than Wal-Mart despite having six times less the sales.

Wal-Mart also turns its inventory over more quickly. The company is expert at merchandising, and the store managers are constantly evaluating the products they offer and the physical location of those products within the store. As a result, they are able to extract a higher inventory turnover out of their operations than is Target. Wal-Mart's inventory turn is 8.8 times (or 41 days), while Target's is 6.8 times (or 54 days). This discrepancy can help to explain some of the differences in the profitability levels of the two companies.

We can see from these ratios that Wal-Mart manages its assets better than does Target. They do not carry receivables on their books for very long, which means that they have more time than does Target to reinvest the income that they have earned. Moreover, they move their inventory faster, reducing inventory storage costs. This also allows them to remit to their suppliers more quickly, lowering their payables.

6) In terms of liquidity ratios, Wal-Mart lags Target. Again, these ratios are slightly deceptive. Wal-Mart's current ratio is 0.9 whereas Target's is 1.7. Their quick ratio is 0.3 to Target's 1.0. Their cash ratio is 0.13 and 0.08. On the surface, this indicates that Wal-Mart is not as liquid as Target. Indeed, for many companies a 0.9 current ratio would not be considered a strong sign, nor would a 0.3 quick ratio. Wal-Mart's liquidity ratios also lag the industry as well, albeit only marginally.

However, there are two considerations worth noting. The first is that Wal-Mart's interest coverage is 9.5, which is significantly higher than that of Target (5.1). This indicates that either Wal-Mart has fewer long-term, interest-bearing liabilities, or that their interest rates are lower. The second consideration is that Wal-Mart operates with significantly lower inventories and accounts receivable than does Target. This means that, inherently, they are likely to have lower current and quick ratios. Indeed, that Wal-Mart has a higher cash ratio indicates that once receivables and inventories are removed, they are more liquid than Target.

7) In terms of debt utilization, Wal-Mart outperforms dramatically. The main reason for this is that Wal-Mart has a much lower degree of leverage than does Target. Wal-Mart has a debt-to-equity ratio of 0.65, compared with Target's 1.37. Target simply has a high level of debt. Wal-Mart makes substantially more profit than does Target, which enhances their debt utilization. Their interest coverage is another statistic that indicates better debt utilization, because it measures the revenue relative to the interest, which is a function of the amount of debt.

All told, Wal-Mart has a healthy level of leverage. They have twice the debt of Target and six times the sales. It is reasonable, however, to deduce that this discrepancy derives more from weakness on Target's part than strength on the part of Wal-Mart. Target is very highly leveraged, over double the normal industry rate. Wal-Mart, by contrast, in leveraged in line with the industry average. Thus, Target is carrying substantially more debt that most of its competitors, including Wal-Mart.

8) The DuPont number is a means by which the ROE can be calculated. It is based on three different components, each representing a component of the operations. These are operating efficiency, asset use efficiency and financial leverage. The specific measures used are profit margin to represent operating efficiency; total asset turnover to represent asset use efficiency and the equity multiplier (assets/shareholder's equity). For Wal-Mart, the DuPont number is:

ROE = 3.4 * 2.5 * (163, 429 / 65, 285) = 21.27

For Target the number is 16.40 (see Appendix B). The largest contributor to Wal-Mart's DuPont is the profit margin, but all components are vital. The DuPont merely confirms what we already know -- Wal-Mart is a stronger company than Target, and Target is overleveraged.

9) Wal-Mart's operating leverage is 1.36 while Target's is -0.11. Wal-Mart's financial leverage is 218.4%; Target's is 88.4%. Wal-Mart's combined leverage therefore is 2.98; Target's is -0.9. The leverage ratios indicate that the degree to which a company's leverage impacts it ability to earn. The figures are somewhat skewed as a result of Target's reduced income and profit levels last year. The degree of combined leverage indicates a firm that has higher volatility. Wal-Mart uses its operating and financial leverage well, while Target has seen its earnings diminish, which indicates poor leverage compared to Wal-Mart.

10) To calculate the cost of capital for Wal-Mart, we will use the capital asset pricing model. The risk free rate will be taken as the five years Treasury, which is yielding 2.05% (Yahoo! Finance, 2009). The historical (approximate) risk premium on the market is 7%. The beta for Wal-Mart is 0.19 (MSN Moneycentral, 2009). Thus, the cost of equity for Wal-Mart is 2.05 + (.19)(7) = 3.38%.

The cost of debt for Wal-Mart shall be taken also with a five-year note. The yield on a five-year note for Wal-Mart is abnormal, so we will the yield on the four-year note, which is 4.2%. The weight of debt is 60%; the weight of equity is 40%. This gives us the following calculation for weighted average cost of capital (WACC):

(4.2)(.6) + (3.38)(.4) = 3.87%

Target has a beta of 1.03, so its cost of equity is 2.05 + (1.03)(7) = 9.26%. A Target four-year has a yield of 4.757%, which corresponds with the higher risk level (A compared to AA) that Target represents over Wal-Mart. This will be used as Target's cost of debt. The weightings of debt and equity are 69% debt and 31% equity. This gives us a weighted average cost of capital for Target of:

(4.757)(.69) + (9.26)(.31) = 6.15%

Target represents a higher risk level compared to Wal-Mart. This is reflected in the bond rating, but also is indicated by the higher degree of leverage. Additionally, the overall stronger financial performance of Wal-Mart hints at a company that should have a lower cost of capital.

11) Appendix E shows the charts of each of these companies for the past three years (MSN Moneycentral, 2009). Wal-Mart's stock lost some value in 2007 at a time when Target's stock gained value. They tracked each other for the first month but began to split in June 2007 with Target climbing and Wal-Mart dropping. In July 2007, both companies broke even, with Wal-Mart stock essentially flatlining and Target stock peaking then falling by the end of the month. The firms tracked each other closely in August. Target showed more volatility in September of 2007, pulling away from Wal-Mart. The firms tracked each other once again in October, with Target again showing higher volatility. It is at this point that the respective performance of the two firm's two begins to reverse course. In November 2007, there is significant volatility in the stocks of both companies. Target begins to underperform Wal-Mart, then outperforms, reversing course on seemingly a daily basis. The year closes out with Wal-Mart exhibiting slow but steady growth and Target stock generally tanking, shedding over 10% of its value in the course of the month.

2008 begins with both firms tracking each other closely, and gaining steadily over the course of the month. February 2008 again sees the two stocks tracking one another in relatively steady pattern. March, however, sees a divergence as Wal-Mart stock begins to gain ground, while Target's stock is both more volatile and heading slightly south. While Target flatlines in May 2008, Wal-Mart stock continues its upward trajectory. Both stocks remain relatively flat for June 2008. In July 2008 Wal-Mart continues it relatively flat pattern, but Target moves slightly downward. At this point, the differences between the two firms have been clearly established. Wal-Mart stock is 20% higher than it was at the start of the period; Target's stock is over 20% lower.

August of 2008 brings recovery both firms, with Target enjoying a stronger rebound in its stock price. The first week of September was positive for both firms, but the rest of the month was less pleasurable as the stock of both companies began a long slide. This slide continued into October, although for Wal-Mart the freefall ended earlier and was less intense. After Wal-Mart's share price stabilized, Target's continued to fall. Wal-Mart struggled in November, showing a drop in share price; Target's share price dropped substantially and at one point it was off 50% from its May 2007 level. The stocks traded in lockstep in December, with Target being more volatile.

This year began with a stronger dropoff for Wal-Mart than for Target. Both stocks fell during February, with Wal-Mart exhibiting greater volatility again. Wal-Mart's March performance was relatively stable with a slight upward growth trend at the end. Target saw its nadir in March, before beginning a recovery. This recovery continued in April, while Wal-Mart's performance continued to decline. All told, however, the intensity of Target's declines, particularly in the latter months of 2008, and the steadiness of Wal-Mart's share price increases, has resulted in Wal-Mart being up slightly over the past two years while Target is down 30% over that same time period.

12) To calculate the net present value of the next five years' earnings at Wal-Mart, we first take the cost of capital, which we established was 3.87%. The five-year average net income growth is 8.39% (MSN Moneycentral, 2009). We then apply the growth rate to last year's net income. This gives us the raw value for each of the next five years. We then discount this back to a present value using the discount rate, and then add each of these present values up to derive the Net Present Value. For Wal-Mart the NPV of the next five years' worth of earnings is $76, 271 (see Appendix F).

The P/E ratio for Wal-Mart over each of the past four quarters is derived from the price at the end of each quarter and the 12-month trailing EPS for each quarter. The P/E for Wal-Mart has been declining steadily over the past year. The company's stock price has reflected weakness in the market overall, which has hampered sale growth at Wal-Mart. The stock price also reflects increased pessimism about Wal-Mart's growth prospects.

Although the trend towards a lower P/E has been evident in each quarter of the past year, the P/E dropped more this latest quarter, reflecting continued weakening investor sentiment. Moreover, Wal-Mart's trailing EPS saw its first decline this past quarter. This occurred because the EPS for Q4 in fiscal 2009 a lower EPS than the same quarter in fiscal 2008. Revenues were slightly higher during this quarter, but so were costs, in particular the selling/general/administrative cost. The result of this was that EPS declined, bringing down the trailing EPS and the P/E ratio with it.

It is worth noting that the current P/E ratio is now 15.1, indicating that Wal-Mart's stock price has improved slightly over the past quarter. That improvement has been marginal, however, and the forward P/E is 12.79, which is lower than the estimated current price/earnings ratio.