Is Walmart the New Costco?

Bank of New York Mellon (BK 1.88%) continues a solid 2021 with third-quarter beats on the top and bottom lines. Motley Fool contributor Asit Sharma analyzes those stories and Walmart's (WMT 0.46%) potential for earnings growth.

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This video was recorded on Oct. 19, 2021.

Chris Hill: It's Tuesday, Oct. 19. Welcome to Market Foolery. I'm Chris Hill. With me today, Asit Sharma. Thanks for being here.

Asit Sharma: Thank you, Chris, greetings.

Chris Hill: Greetings. We've got some big retail news to talk about, but we're going to start with some earnings, and we'll go consumer products first. First-quarter profits in revenue came in higher than expected for Procter & Gamble (PG 0.54%). Shares are down a little bit. They were down a little bit this morning, they've evened out. Because profits were a little bit lower than a year ago, and also costs are going up, which I guess when you think about everything that Procter & Gamble makes and sells, nobody should really be all that surprised.

Asit Sharma: I agree, Chris, that's really the big message here. Organic sales were up a nice 4 percent. Not bad for a consumer goods multinational conglomerate. Net sales of $20.3 billion, just marking how huge this company is. But transportation issues, supply chain issues, very similar to other companies as we have gone about these last few months. These were a little bit of a thorn in the side of Procter & Gamble for this earnings period. They took a hit on their gross margin. And as a result, the bottom line didn't flourish as much as it did in the prior-year period. Now, if you're a shareholder, maybe you feel good about the company's operating cash flow, $4.6 billion for the quarter, and as is their habit, Procter & Gamble returned 5 billion bucks of cash to its shareholders split between dividends and share repurchases. Now, I hate to sound so curmudgeonly on a Tuesday, Chris, [laughs] but I've had a long-standing beef with the way Procter & Gamble manages its balance sheet and its cash flow. They have a perennial working-capital deficit and always are adding on debt to the bottom line so that they can use all of operating cash flow plus a little bit more to return money to shareholders, to pay those dividends and repurchase shares, that is. Over the last 10 years, Procter & Gamble has returned 197%, that's on a total return basis, versus the S&P 500, which has returned almost 350% on a total return basis. This strategy hasn't worked for a long time. My one wish for Procter & Gamble is that they would send less money home to shareholders and maybe focus a little bit more on some faster growing areas of that big consumer goods space.

Chris Hill: Yeah, I know that Procter & Gamble gets their name checked now and then when people are thinking about what we consider to be the classic blue chips dividend payers. But to your point, it's absolutely not at the top of that list in the way that I think Johnson & Johnson has been for at least a few years now. I think that you go back a decade or so, I think they did a nice job of paring back their overall portfolio. Anyone listening right now, if we were to go through everyone's homes, it will take a little bit of time because we have dozens of listeners, but everybody's got at least one Procter & Gamble product in their house, if not multiple. They did a nice job of pairing that back. But to your point, it's almost like they didn't have a next move in terms of what they were doing with their products.

Asit Sharma: I'm trying to remember off the top of my head, I feel like it was something like 70 brands, so please don't quote me here. But let's just put it this way, it was an enormous number of brands when you look at their entire portfolio, but that portfolio being so big, spread over multiple areas of the consumer goods industry from healthcare, to beauty, to household goods, cleaning products, et cetera. It's just difficult at this size for Procter & Gamble to make meaningful change. And then of course, as they might have been coming into some momentum, they got a little bit of a temporary boost from COVID, and now are clawing back with the aftermath of COVID. It's almost, too, as if circumstances have prevented them from riding a very persuasive narrative for investors. But personally, I don't think much will change until they start to look very closely at how they're utilizing cash. It hasn't worked in all these years. They're so big, it really isn't a persuasive investment thesis to your point about the dividend. We'll see, but all in all, look, not a bad quarter in terms of that top-line growth in organic sales. They do have that going for them. We'll check back in maybe next quarter.

Chris Hill: Yeah, and the last thing I'll say is, I do respect the fact that they did not change their full-year guidance, that they basically said, "Yeah, costs are going up, but we can handle it."

Asit Sharma: Yeah, you have to give them some credit there and also the management team is pretty good at being able to take adverse changes within their supply. We're going to talk about another company that does this very well also in just a minute here. But they're able to react because they do have very high-quality manufacturing and have a firm grasp of all of their supply and supply chain, so that is to their credit, Chris. Again, I didn't want to sound curmudgeonly, so that's a positive note to leave it on and move to the next company.

Chris Hill: We'll move on. Third-quarter profits in revenue were higher than expected for Bank of New York Mellon. They increased their fee income. You were pointing this out, because this is one of those bank stocks that does not leap to mind when I think about the big banks in New York City. It's done well. The stock has done well over the last 12 months, although even though it's up, I think just north of 50 percent over the last year. That is still solidly trailing the likes of BofA [Bank of America], and Wells Fargo, and others.

Asit Sharma: That's true. The same for me, Chris. Bank of New York Mellon is not the first stock I think about when I'm looking at large capitalization banks as leading brand names in the U.S. It is usually within the top 10 in terms of total assets. I think currently it's the ninth largest bank by its asset base. I like their business model because over the years, they've relied less on just brute interest income, which is the bank's basic formula as to earn more money on the deposits they take in than they're paying in interest. They've become more of a wealth management company, more of a fee-based company. This quarter revenue was up 5 percent. A lot of that is coming from fees for different services. The other thing that catches my eye about Bank of New York Mellon is their investment in technology. They're starting to play more in the fintech space, but in a context that works for them. For example, this quarter, they talked up a collaboration with Verizon that will help them be the first company to send request for payment messages directly to consumers bank accounts. This is part and parcel of treasury management, but also this function is consumer facing. These types of innovations which don't try to turn the company into some fintech upstart, but feel more natural, I like. I was surprised, Chris, I've got one quiz question for you today and I don't expect you to be anywhere close on this because I was so way off of this. Do you know how much of assets Bank of New York Mellon has under management?

Chris Hill: No, and to guess it would just be pure folly.

Asit Sharma: OK. I guess in the hundreds of billions, I was way off. They have $2.3 trillion of assets under management. That shows us there that there's a very appreciable asset base that they can earn fee revenue off of, whether it's private management, wealth management services, what have you. I like this revenue diversification that they've got. For a big bank, it's what you want just short of getting into those trading activities. Investment banking activities, which make up so much of one quarter's returns for some bigger banks like JPMorgan or Goldman Sachs.

Chris Hill: Well, and you touched on this. They need to try something new. I mean, when you look at them just in terms of their size and what they do there, it's almost like they're stuck in the middle. We were talking recently about JPMorgan Chase, which is the biggest of the big banks. But even compared to the likes of Bank of America or Wells Fargo, Citi (NYSE: C), and others. Bank of New York, Mellon is the little kid brother.

Asit Sharma: The middle child.

Chris Hill: Yet it's not like it is this dynamic upstart business. It's not even like they are a smaller community bank and with maybe some of the potential upside of a business like that. Hopefully, they keep trying to innovate because if they're just trying to play the exact same game as their bigger competitors. It's not to say that they're going to go away. It is to say that they're just going to continue to lag the field.

Asit Sharma: Yeah, so much of this is coming down to nomenclature as it's grown to be this big but still middle size, like what happened with Prince when he changed his brand to the Artist Formerly Known as Prince. This is the bank formerly known as one of the largest of the regional banks. But to your point, it's become so big. You really can't think of it as a regional bank anymore, at least I can't, nor can I put it in the same breath as those huge houses which have multiple types of trading activities. It is something of now this big animal which manages assets, works up that fee component and is trying to invest in technology. Yeah, I agree with you there, if they've got to do something different, they have to innovate. I see signs of that, but trailing their peers. I mean, it's such a great environment for banks we're just looking this morning. The Dow Jones U.S. banks index is up 40 percent this year. These are banks. Of course, coming off a very volatile 2020 which was hard year for banks, but it's trailing that index. Its stock is up 35%. You're right there that innovation and investments still has a payoff down the road but the middle is a difficult place to be.

Chris Hill: Well, again, to end on a positive note, I'm pretty sure you just compared Bank of New York, Mellon to Prince, which is about the nice accomplishment they're going to get all week.

Asit Sharma: Absolutely. Over the long term, you want to be compared to Prince, not the Artist Formerly Known as Prince.

Chris Hill: Shares of Walmart up after Goldman Sachs added the stock to its conviction buy list. I think I mentioned this recently when I see upgrades like this, my thought is always the same, which is I don't care that it happened. I want to know why it happened. In the case of why Goldman Sachs added Walmart to its conviction buy list, it's built around earnings growth, which is not a phrase investors traditionally associate with the business like Walmart, but the reasoning appears to be sound.

Asit Sharma: We're used to thinking of Walmart as a slower-growth proposition, so we certainly don't think of Walmart in terms of sales growth, but their earnings growth you can be convinced by, if anything, I think the past two years have illustrated for us that those really huge retailers like Walmart, especially Target, I would say Costco, that have huge balance sheets and have spent years investing not just in supply chains, but their own internal technology. They're best equipped to weather any kind of storm. They can be opportunistic in difficult times and they retain the ability to grow and compound those earnings when things return to normal. Walmart has shown a lot of evidence of this. It's been so competitive with Amazon.com over the last, I'd say, five to seven years and trying to figure out how to do e-commerce. But they couldn't have achieved that without the big balance sheet that they have. 

When you start to think about why such a big mammoth company would get on a conviction list for earnings growth, to me, it means these earnings are predictable. I mean, this is the way that I look at Walmart. If anybody has the ability in retail to improve earnings for the next five years, it's going to be Walmart, it's going to be target because they were able to make investments. They weren't stretched for dollars as they grew decades ago but this slower-growth period is impressive. Just to remind listeners, Chris, I believe it was the two of us talking about Walmart's in Q2 report for this year, their comparable transactions grew 14.5% on a two-year stack. Comparing comp sales not to last year, which is we should take that with a grain of salt, but the year before the 2019 year. There's still also capable of top-line growth, which in turn can boost margins and profits if you can hold your cost structure steady.

Chris Hill: There have been times in the past when any number of analysts have come out and made the case for buying Walmart. And a lot of times, a big part of that case was the stock had been beaten down. Shares of Walmart today are trading I think 5% or 6% below its all-time high. It's one more nice reminder that just because the stock is at or near its all-time high, it doesn't mean it's a bad time to buy.

Asit Sharma: Very much so and this is almost the Costco-ization of Walmart in terms of investors' eyes. I think Costco has enjoyed a lot of confidence from investors over the years because it's got that locked-in, annualized recurring revenue from its fee membership. They do everything else right to bring the business in. Costco has never been quite a stock where lots of analysts will pilot on a bad earnings report and say oh, it's beaten-down bite now. In all weather's, I think Costco is recommended and they perform year-after-year, Walmart starting to look a lot more like that, although they don't have that locked-in component. What they do have is customer loyalty across a lot of different economic strata that we look at, and that's impressive to me how much of a wide base of customers they've been able to retain over the years. So yeah, I mean, this is something don't let it sleep on, if you're looking for a little bit of balance in your portfolio by saying why not to some of these big names?

Chris Hill: Real quick before we wrap up two quick things. First, happy birthday to my sister. Yes, she shares her birthday with the awful day in 1987 for investors where the stock market fell 22 percent in a single day.

Asit Sharma: You never forget her birthday? Happy birthday by the way to your sister [laughs].

Chris Hill: I'd like to think I remember your birthday well before '87. I was a kid then, maybe I didn't do such a good job. Again, drops in email [email protected]. We're planning an apropos-of-nothing episode. [MUSIC] If you had suggested topics for that, shoot into [email protected]. Asit Sharma, great talking to you as always, thanks for being here.

Asit Sharma: So much fun, Chris. I appreciate it.

Chris Hill: As always, people on the program may have interest in the stocks they talk about on the Motley Fool may have formal recommendations for or against buyers sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Board. I'm Chris Hill. Thanks for listening. Let's see you tomorrow.