<THE RULE MAKER PORTFOLIO>

Is Wal-Mart a Rule Maker?

by Al Levit (TMF Early)

GLENDALE, CA (May 12, 1999) -- Today, it's my turn to discuss a company that doesn't quite cut it as a Rule Maker, and I've chosen Wal-Mart Stores (NYSE: WMT). With over $137 billion in annual revenues, the Bentonville, Arkansas company is not only the world's largest discount retailer, but the world's largest retailer -- period. The company's everyday low prices, dedicated customer service, friendly "People Greeters," and ultra-efficient distribution make this a retail force to be reckoned with -- but is it a Rule Maker?

When Sam Walton opened the first Wal-Mart store in 1962, a Rule Breaker was born. This top dog and first mover created the discount retail industry and held onto the lead by capitalizing on its visionary leadership and inept competition. The company's well-chronicled business excellence has rewarded shareowners handsomely for decades. Over the past 25 years, the stock has racked up an amazing 34.6% compound annual return (including reinvested dividends). A chart of the stock's performance since 1985 makes the stellar returns of the S&P 500 (represented by the blue line) look downright paltry. Despite all this success, this Rule Breaker never became a Rule Maker -- it's a Merchant King.

To see why the company is not a Rule Maker, please see the Ranker that I posted yesterday. With a total score of 40 points, Wal-Mart barely makes it into Tier 2 status. The story here is the company's poor showing on the financial location metrics. Low gross and net margins, a low cash-to-debt ratio, and a good, but not great, Flow ratio limit the company to only 4 out of 14 possible points. The company's margins simply aren't near our standards, and cash is only 24% of debt. Even the Flowie just barely inches under our 1.25 standard.

Wal-Mart may not be much of a Rule Maker, but a lot of people still think that it's a heckuva great company, including me (I'm a shareholder). With its network of nearly 2,900 Wal-Mart and Sam's Club stores, the company delivers high-quality merchandise at outstanding prices to more than 90 million customers each week. The recent experience of my wife is typical. She went shopping at Wal-Mart with her mother for a few items and came back with bags full of stuff we're using every day. Her total bill was over $200.

However, Wal-Mart does not make profits like a Rule Maker. The company is in a low-margin business that requires tight expense control and high asset turnover (see ROE series parts 1, 2, 3, 4 for a good explanation) to put profits on the bottom-line. Despite the company's highly-automated distribution centers and world-class inventory management, the brick-and-mortar stores necessitate a substantial investment in inventory, which prevents the company from achieving an ultra-low Flowie like that of Microsoft or Yahoo!. Also, the retailer uses a fair amount of debt to keep building new stores.

Moreover, unlike Rule Makers such as Microsoft, Cisco, and Pfizer, Wal-Mart doesn't have any legal protection over its business practices and products to keep competitors at bay. If someone else comes in with a chain of stores that do the job better, Wal-Mart has no legal way to stop them. Of course, at this point, duplicating Wal-Mart's thousands of stores and sophisticated distribution system would be extraordinarily difficult. Clearly, the retailer's entrenched position forms a significant barrier to entry by a competitor, but most people would agree that patent protection is an even better barrier. Plus, Wal-Mart is already facing serious competition from Dayton Hudson's (NYSE: DH) "upscale discount" Target Stores and Costco's (Nasdaq: COST) super-efficient wholesale clubs.

A company facing fierce competitors and operating on 3% profit margins can go from profit to loss relatively quickly. On top of that, Wal-Mart sells for a well-deserved high multiple to its current earnings. If those slim profit margins fall significantly, the price of this stock could drop even more sharply. In this situation, the typical Rule Maker plan of buying and holding for 10 years may not guarantee success.

Thus, we see that Wal-Mart's competition-rich industry is not suitable for a Rule-Making investor. It's unclear whether the low-margin retailing business will make money hand over fist for years to come. Then again, Wal-Mart has managed to keep the cash pouring in for decades now. While mutual funds will tell you, "Past performance does not guarantee future returns," strong historical performance isn't a bad sign, either.

What does all this mean for Merchant King Wal-Mart? Personally, I think it's a good investment, but it's certainly not a Rule Maker, and I don't treat it as such in my portfolio. I feel that I need to pay extra-close attention to Wal-Mart's operational performance, especially as it compares to that of its well-run competitors.

In short, compared to most Rule Makers, Wal-Mart carries more risk, but also offers more potential reward.

By the way, the above-linked Ranker does not include Wal-Mart's earnings for the most recent quarter. For a report on those earnings, which beat Wall Street's expectations, see yesterday's Fool Plate Special.

That's all from me today. Tomorrow, Matt will be looking at entertainment giant Time Warner (NYSE: TWX).

Fool on,

Al

05/12/99 Close

Stock Change    Bid
AXP   -1 13/16  126.00
CHV   -3         95.06
CSCO  +6 7/8    118.75
EK    +  1/2     78.50
GM    +2 5/8     88.38
GPS   -  5/8     62.25
INTC  +  3/16    62.50
KO    -  7/16    66.44
MSFT  +  5/8     80.50
PFE   +1 3/16   115.75
SGP   +  1/2     49.31
TROW  +  7/16    39.94
XON   -2 9/16    79.06
YHOO  -4 1/16   169.94

                  Day     Month  Year    History
        R-MAKER  +0.47%  -0.48%  11.54%  41.14%
        S&P:     +0.62%   2.16%  11.28%  37.64%
        NASDAQ:  +1.55%   2.50%  18.87%  57.70%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     80.50   105.70%
   6/23/98   34 Cisco Syst    58.41    118.75   103.30%
    5/1/98   55 Gap Inc.      34.37     62.25    81.12%
   2/13/98   44 Intel         42.34     62.50    47.62%
    2/3/98   22 Pfizer        82.30    115.75    40.65%
   2/17/99   16 Yahoo Inc.   126.31    169.94    34.54%
   5/26/98   18 AmExpress    104.07    126.00    21.08%
    2/6/98   56 T. Rowe Pr    33.67     39.94    18.60%
   8/21/98   44 Schering-P    47.99     49.31     2.75%
   2/27/98   27 Coca-Cola     69.11     66.44    -3.86%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko    63.15     78.50    24.31%
   3/12/98   20 Exxon         64.34     79.06    22.89%
   3/12/98   17 General Mo    72.41     88.38    22.06%
   3/12/98   15 Chevron       83.34     95.06    14.06%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
   6/23/98   34 Cisco Syst  1985.95   4037.50  $2051.55
    2/3/98   48 Microsoft   1878.45   3864.00  $1985.55
    5/1/98   55 Gap Inc.    1890.33   3423.75  $1533.42
   2/13/98   44 Intel       1862.83   2750.00   $887.17
    2/3/98   22 Pfizer      1810.58   2546.50   $735.92
   2/17/99   16 Yahoo Inc.  2020.95   2719.00   $698.05
   5/26/98   18 AmExpress   1873.20   2268.00   $394.80
    2/6/98   56 T. Rowe Pr  1885.70   2236.50   $350.80
   8/21/98   44 Schering-P   2111.7   2169.75    $58.05
   2/27/98   27 Coca-Cola   1865.89   1793.81   -$72.08

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Eastman Ko  1262.95   1570.00   $307.05
   3/12/98   20 Exxon       1286.70   1581.25   $294.55
   3/12/98   17 General Mo  1230.89   1502.38   $271.49
   3/12/98   15 Chevron     1250.14   1425.94   $175.80

                              CASH     $70.09
                             TOTAL  $33958.47

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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