With the 10-year Treasury bond paying a yield of less than 2.5%, and many CDs paying less than 2%, investors are on a hunt for income. Though Wal-Mart Stores (NYSE:WMT) can't be considered a high-yield stock, there are many investors looking for income from the retail giant.
In the last five years, the company's average dividend increase has been around 12%. Should income-hungry investors expect more of the same, or are Wal-Mart's best dividend days behind it?
What changed over the last five years?
In the last several years, change in the retail industry has been constant. Some changes have been obvious to spot like the move toward online sales. In addition, Wal-Mart's traditional competitors like Target (NYSE:TGT) and Best Buy (NYSE:BBY) have upped the ante by matching prices and offering exclusive deals.
Where Wal-Mart's dividend is concerned, if we look at the company's recent quarter alone, investors probably assume the payout is safe. In the last three months, the company generated enough free cash flow to produce a payout ratio of less than 40%. Compared to Target's payout ratio of 62% or Best Buy's 33% ratio, it seems like Wal-Mart is doing fine.
However, in recent years, Wal-Mart's free cash flow situation has changed. In the last three years, the company's average free cash flow payout ratio was around 52%. In the last four quarters, Wal-Mart's payout ratio rose to nearly 59%. The problem is that Wal-Mart's sales growth is slowing down, and the company's cash flow is following suit. The reason the company's payout ratio doesn't look too bad is that Wal-Mart cut its capital expenditures by more than 25% year over year.
The point is, just looking at one quarter's payout ratio doesn't give investors enough information. Wal-Mart needs to reverse its cash flow challenges to continue growing its dividend.
Good things come in small packages
For the largest retailer in the world, the great irony is that Wal-Mart's future could lie in building smaller stores with a targeted selection. In the last two quarters, Wal-Mart's Neighborhood Market stores have shown the best comparable-store sales growth of the chain's multiple formats.
Just as an example, Wal-Mart's U.S. comparable sales were flat year over year, but the Neighborhood Market comps were up 5%. In a similar way, Best Buy decided last year to close 50 of its big-box stores in order to open 100 Best Buy Mobile stores. Target is also getting in on the act with its City Target stores.
What each of these chains understands is that large-format stores don't fit in every town. Customers may be interested in the items each store carries or the better pricing a megaretailer can afford. However, walking through a store with tens of thousands of square feet isn't their idea of a great shopping experience. While Wal-Mart Neighborhood Market holds promise for the company, there are around 4,000 Wal-Mart stores in the U.S. alone, and it will take years of development before this small format changes the company's bottom-line growth.
What's the bottom line?
For investors collecting Wal-Mart's yield of about 2.5% and expecting similar dividend increases as the last five years, they may need to adjust their expectations. The average analyst expects Wal-Mart to increase its annual earnings per share by 8% over the next five years.
Relative to the company's peers, Wal-Mart's earnings growth already looks weak. Even with Target's Canadian challenges, analysts expect the company to grow earnings by 11%. Best Buy is trying to turn its business around, and over the next few years analysts expect EPS growth of more than 16%.
As if Wal-Mart's substandard growth wasn't enough of a challenge for investors, even 8% earnings growth may be difficult for it to achieve. In the last three months, Wal-Mart increased sales by 2.1%, yet diluted EPS increased by just 3.5%. Considering this was in a quarter when e-commerce sales increased by 27%, investors should correctly question what it will take to generate 8% earnings growth.
The bottom line is that Wal-Mart's yield is better than the 10-year bond. However, if investors expect 8% earnings growth and significant dividend increases in the future, that future looks very unlikely.
Chad Henage owns shares of Target. 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.