Should You Short Wal-Mart?

I know. You can't believe I wrote that headline, can you? You've got good company. Some of my colleagues told me the same minutes after I claimed this topic for today's news.

A smiley face with a blue reflective glow
What got me started was this discussion thread on our Wal-Mart (NYSE:WMT) board. (There's a subscription required, but you can get free access for 30 days by clicking here.) The argument, in sum, is that Wal-Mart is becoming way too much like the old Kmart. The yellow smiley face, it seems, reminds more than a few of us of those old blue light specials, including yours truly.

The poor get poorer
That's because data backs up the association. Target (NYSE:TGT), for example, attracts consumers who make upwards of $20,000 more annually than your average Wal-Mart shopper. And while it's remarkably callous to say so in light of the tragedy that's befallen the southeastern United States, Wal-Mart has exactly the wrong kind of customer base to engineer a speedy recovery from the havoc Katrina has wrought.

Don't get me wrong: I'm not saying storm damage will materially harm Wal-Mart. The Bentonville Behemoth takes in more than $70 billion in sales per quarter. Even the reported 123 store closings and looting will probably amount to a barely noticeable blip.

I'm talking instead about the long-lasting consequences of the hurricane: higher gas prices; lost income from furloughs or, worse, layoffs; and, of course, substantial out-of-pocket costs to replace needed items. Even the president says the recovery will take years. Now, ask yourself: Who is going to have the hardest time getting back on their feet? If you're answer is lower-income workers, you're right. And where do these folks tend to shop? At Wal-Mart.

Attention, bargain shoppers
Wal-Mart's stock Wednesday hit a new 52-week low, according to The Wall Street Journal. (The shares were trading for $44.96 per stub at the close.) No doubt that leads some to believe that the herd is heeding Jim Cramer's frothy call to sell Wal-Mart, but I don't think that's true. Instead, I think there's a growing minority that thinks Wal-Mart has suddenly become a screaming buy.

Some of them are even proven expert value investors, as my Foolish colleague David Meier pointed out to me. Among the list: Bill Nygren, who co-manages the highly successful Oakmark (FUND:OAKMX) fund; Nebraska-based investor Wally Weitz, who has earned a following among Warren Buffett fans; and our own Whitney Tilson, a fund manager and long-time Fool, whose columns have stirred thinking among thousands, if not millions, of readers of these digital pages.

Knowing this, I had to wonder whether my initial impression -- that Wal-Mart's stock was, at best, fairly valued -- was dead wrong. So I followed the advice of fellow Fool Bill Mann and dug deeper. After doing so, I'm still convinced I'm right. Follow along, please.

Sam goes to China
When I first eyeballed the cash flow numbers for Wal-Mart, I found that owner earnings were a paltry $1.7 billion over the trailing 12 months. That seemed remarkably low for a company doing nearly $300 billion a year in sales. Doing a discounted cash flow (DCF) analysis of the stock using that figure as my basis yielded predictably poor results.

Obviously, that wasn't a fair calculation. For one, it didn't take into account that Wal-Mart has made good capital investments that have bolstered international growth. Check the numbers. Each month since April, Wal-Mart has increased its contribution to sales from overseas stores from the year prior. And this trend should continue. Wal-Mart reported in its most recent 10-K filing that 40% of new stores will be opened in international markets during fiscal 2006. (Check "Future Expansion" on page 30.)

Certainly at some point, international expansion opportunities will begin to dry up, but that's probably more than a decade down the road. And even then cash flow would remain strong as the need for capital expenditures waned. That would leave an already well-capitalized Wal-Mart sitting on a whole lot more moolah usable for dividend increases, share buybacks, and general improvements. To account for this possibility -- which, I'll admit, is hardly a given, I just think it's more likely than not, given the data currently available -- I adjusted capital expenditures to a more normalized 4.1% of total revenue in figuring a valuation for the shares. (A five-year average of capex as a percentage of total revenue equaled 4.1%.)

The problem is that, even in that rosy scenario, you still end up with only $4.4 billion in free cash flow to work from. Here's the math: $16.7 billion in trailing 12-month operating cash flow minus $12.3 billion in capex. ($12.3 billion is 4.1% of Wal-Mart's $301 billion in trailing 12-month revenue.)

Bear in mind, too, that this isn't a conservative estimate. Actual trailing 12-month free cash flow barely exceeded $3 billion. ($16.712 billion in operating cash flow minus $13.672 billion in capex equals $3.04 billion.) Here are the final inputs I plugged into the DCF calculator available to subscribers to Motley Fool Inside Value (click here for a free trial):

• A 10% discount rate.
• $4.4 billion in free cash flow.
• 4.18 billion in shares outstanding.

I then applied three different growth rate scenarios for the next five years, the next five after that, and ongoing. The middle set -- 14% for the next five years, 9% for years six through 10 (to account for outsized international growth), and 4% ongoing -- most closely resembles what analysts expect, according to Yahoo! Finance. Check out the results:

The Foolish bottom line
That's right. Under my most optimistic assumption, Wal-Mart is, at best, slightly overvalued and could even be vastly overvalued. So -- I can't believe I'm saying this -- I'm going to have to go against the value gurus I've come to admire and instead agree with Cramer.

But should you short? I'm not going to, not unless the stock jumps dramatically without demonstrating material improvement in the underlying business. There's just too much risk involved. First, Wal-Mart still trades at a historically low multiple to earnings. And, second, international expansion could be waaaaay more successful than any of us anticipate. In sum: There are legitimate reasons to expect Wal-Mart to go higher over the short term. Just not much higher.

So, at least for now, this Costco (NASDAQ:COST) member will refrain from the unthinkable. But you'd better believe I'm still looking for a chance to go shopping. My portfolio could use a bargain.

Have you enjoyed investing success? Consider giving something back in this time of need. You can donate to the Red Cross' Hurricane Relief Effort by clicking here.

Do you loathe the thought of pricey tech stocks? Do you go to the mall and only shop in the bargain aisle? Do garage sales actually appeal to you? If so, Motley Fool Inside Value was made for you. Learn how Philip Durell and our Foolish band of value-investing analysts buy stocks on sale by taking a risk-free trial today. Your portfolio will thank you.

Fool contributor Tim Beyers can't recall the last time he shopped at a Wal-Mart. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what's in his portfolio by checking Tim's Fool profile here. The Motley Fool has an ironclad disclosure policy.