What’s Really Going on at Wal-Mart?

Wal-Mart isn’t impressive to investors right now, but the Wal-Mart you know right now isn’t the Wal-Mart you will know in five to 10 years.

Jun 28, 2014 at 11:11AM
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Wal-Mart Stores (NYSE:WMT) has 11,000 Wal-Mart store locations around the world, with 4,848 of them in the United States. The United States still plays the biggest role in Wal-Mart's operations (59% of sales). Therefore, you should know about the progress, or lack thereof, being made. You might be surprised. 

Recent results
As you might already know, comps sales (sales recorded at stores open for at least one year) declined 8 basis points year over year in the United States. This was primarily related to severe winter weather and Supplemental Nutrition Assistance Program-related headwinds.

Weather is a short-term headwind, and it affected comps sales by 20 basis points. That being the case, comps would have improved 12 basis points excluding the severe winter weather. Additionally, according to the Nielsen Company, Wal-Mart U.S. gained 23 basis points in market share across food, consumables, and over the counter for the quarter.

Wal-Mart's continued investment in price (offering lower prices to its customers than its competitors)  in order to drive more traffic to its stores led to a 17 basis point decline in gross profit. Inventory also increased 5.3%, but this was due to new store growth and slower sales in weather-related categories. Once again, temporary events.

Neighborhood Market saw comps sales increase 5%, with comps traffic growing at a 4% clip. Neighborhood Market stores have seen the most strength in produce, meat, adult beverages, and pharmacy. Neighborhood Market stores performed well despite inclement weather -- a sure sign of strength. Neighborhood Market stores are clearly performing well, but let's take a look at the domestic performance as a whole.

Segment breakdown
Wal-Mart now reports in five segments instead of six. Those five segments include: grocery, health and wellness, general merchandise, apparel, and home.

SNAP benefit reductions created a 90 basis point headwind (sales growth) for Wal-Mart in the first quarter. Despite that being the case, Wal-Mart has seen an improving trend in its grocery segment, which accounts for 55% of total sales. Consumables suffered low-single digit negative comps last quarter due to industry softness and modest price deflation, but food delivered a positive comp thanks to strength in meat, produce, and dairy. Wal-Mart is fighting to keep prices low despite cost inflation pressures.

Health and wellness improved 150 basis points sequentially, primarily thanks to strength in pharmacy. Branded-drug inflation and a strong increase in script counts played big roles for a positive comp, and over the counter performed well thanks to a robust allergy season, which offset a weak flu season.

So far, two of the five segments were positives, not negatives. However, score 1 in the negative column due to general merchandise. Weather played a role, but remember, that's a short-term headwind. What's more concerning is that Wal-Mart cited a changing industry dynamic. This, in turn, is a likely reason why Wal-Mart is growing its small-box stores -- to better fit consumer trends. The electronics category was the softest area in general merchandise. Specifically, Wal-Mart blamed the negative comps in general merchandise on entertainment (industry deflation) and hardlines (weather-related).  

Apparel and home both delivered positive comps. In apparel, activewear saw double-digit comps growth, and shoes and children's apparel also performed well. In the home category, national brands offering value to customers and an expanded assortment played key roles. These two segments taken together show that Wal-Mart is changing to meet current demands.

If you're keeping score at home, that's 4:1 in favor of good news. However, Wal-Mart U.S. expects second-quarter comps to come in flat due to a challenging retail environment. This might seem like bad news, and it is bad news for short-term traders, but it's not bad news for long-term investors. Here's why.

Long-term benefits
 First, below is an example of Wal-Mart's unimpressive margin growth over the past five years. However, remember that Wal-Mart is still massively profitable and that it's outperforming its biggest brick-and-mortar competitor, Target (NYSE:TGT) over the same time frame:

TGT Profit Margin (Annual) Chart

Target profit margin (annual) data by YCharts

Free cash flow performance paints a similar picture for Wal-Mart. Despite not seeing consistent growth, that's not expected right now due to the retailer's transformation with an increased focus on small-box stores and e-commerce. And even though there's not consistent growth, this massive cash flow generation allows for consistent share buybacks and dividend payments.

WMT Free Cash Flow (Annual) Chart

Wal-Mart free cash flow (annual) data by YCharts

As far as dividend payments go, Wal-Mart currently offers a dividend payout ratio of 39%. That's somewhat generous but not as generous as Target, which currently offers a dividend payout ratio of 56%.   

That's interesting, but what's more interesting is that while most retailers have trouble driving revenue while transforming themselves, Wal-Mart has continued to deliver top-line growth:

WMT Revenue (TTM) Chart

Wal-Mart revenue (trailing-12 months) data by YCharts

There is no question that Wal-Mart is capable of cutting costs if necessary in order to drive profitable growth. All it would have to do is close underperforming supercenters (or Sam's Club stores). And this wouldn't be a net negative because Wal-Mart is seeing growth in other areas, such as small-box stores, in e-commerce, and in most segments at its larger stores. Therefore, freed-up capital would be applied to these higher-growth areas, which means revenue would likely continue to head north. 

The Foolish conclusion
Some investors think Wal-Mart is dead. If that's the case, then it's rising from the grave. However, this is a false diagnosis. Wal-Mart is slowly but surely navigating itself in the right direction in order to match current and future consumer trends. And its massive cash flow generation allows for maneuverability when it comes to long-term profitable growth, all the while pleasing investors with shareholder returns. Investors would be wise to take another look at Wal-Mart. 

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Dan Moskowitz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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