Rumors have been circulating in recent weeks, from The Wall Street Journal and other sources, that Wal-Mart (NYSE:WMT) has a secret plan to spin off Sam's Club. Analysts have been suggesting this move for several years as a way for the retail behemoth to breathe life into the company's stock price, which is down 20% over the past five years. But this time, there could be something to the rumors.
Let's explore whether removing Sam Walton's namesake format from the company would make sense for shareholders, and how it might be accomplished.
Size does matter
A significant portion of stock price is related to growth potential, and investors have rightly wondered in recent years how much growth can be left for a company that is already north of $300 billion in sales. Would the exit of Sam's Club from the Wal-Mart portfolio create a smaller company with higher growth prospects?
The answer is yes, but only to a small degree. Wal-Mart reports sales and operating income by segment. From the 2006 annual report, we can view the company with and without Sam's Club on those metrics:
|
Segment Results, | Sales Growth |
Operating |
Operating Income |
|---|---|---|---|
|
Without Sam's Club |
9.9% |
8.8% |
6.8% |
|
With Sam's Club |
9.5% |
8.7% |
6.4% |
Growth rates improve, but only slightly. Operating income as a percentage of sales shows a more noticeable bump from 6.4% to 6.8%. The question is, will any of the above improvements drive a P/E ratio higher than the trailing-12-month 17.5 mark that the company currently sports?
These marginal growth-rate improvements don't light my fire. The company is already so big that spinning off a division representing 12% of its total sales doesn't move the needle very much.
What's more, the numbers shown above represent the past, and future growth rates will likely be different. The domestic warehouse-club business is approaching saturation, while Wal-Mart has stronger international growth potential. The company has enjoyed big success in the U.K., Mexico, and Canada. However, recent exits from Germany and South Korea have shown that the Smiley Face doesn't yet have a formula that works everywhere.
Buying and distribution synergies
Would Wal-Mart lose important synergies from the loss of Sam's Club? I don't think so. Retail synergies usually come in two varieties: buying and distribution.
On the buying side, Sam's Club buys many of the same products as the Wal-Mart stores so, but the package sizes are different. That means manufacturers have different production lines and runs of merchandise to create the larger sizes for Sam's. Furthermore, there might be some synergies from global sourcing of raw materials, but I don't see a major loss here. How much extra buying clout does a company get from being 40% of a manufacturer's business instead of 35%? With or without Sam's Club, Wal-Mart owns a large percentage of its supplier base.
You would think that distribution synergies are a big deal, but they really aren't. Wal-Mart and Sam's Club employ completely different distribution models. Wal-Mart uses distribution centers where product is received and slotted for later delivery to the stores. Sam's Club, meanwhile, uses cross-dock facilities that move pallets of merchandise from incoming to outgoing trucks; none of the merchandise is stored. Wal-Mart wouldn't lose any noticeable distribution efficiency from the exit of Sam's Clubs.
Spinoff vs. outright sale
A spinoff is by far more likely than a sale. An outright sale could happen in two ways, but neither appears likely: Wal-Mart could look for a strategic buyer to complement an existing business, or it could find a private equity buyer.
Who could be a strategic buyer for Sam's? Costco doesn't make sense, because there is too much overlap on the real estate. Five to seven years ago, I could have seen it, when Costco was primarily on the coasts and Sam's was mostly located in the central United States. In the past few years, Costco has invaded most of Sam's strongholds, including Dallas, Atlanta, Minneapolis, Pittsburgh ... the list goes on and on. Plus, Costco and Sam's represent 85% of the domestic warehouse-club business by store count, so SEC approval of a merger could be problematic. To quote from Monty Python, BJ's (NYSE:BJ) as a strategic buyer is "right out."
The only other strategic buyer I can envision is Berkshire Hathaway (NYSE:BRK-A), which is not short of cash to invest. Its most recent letter to shareholders stated: "We continue ... to need elephants in order for us to use Berkshire's flood of incoming cash." Sam's is an elephant, and there are some eerie undertones here. A few years ago, Berkshire bought the McLane's distribution network from Wal-Mart. There are some commonalities in that Sam's is as much a distribution network as it is a retailer, and McLane does supply Sam's with tobacco and candy products.
Berkshire used to look for high-margin companies with unique competitive advantages. Sam's Club doesn't fit either of those criteria. But with Berkshire's purchase of McLane, along with recent investments in railroads, it's at least a possibility that the Oracle of Omaha is taking a shine to the distribution business.
The private-equity route is also a possibility, but Sam's doesn't fit the traditional private-equity profile of a troubled company that can be turned around to generate a substantial profit. Where's the upside in buying a well-performing retailer that's been the clear second-best in its segment for years? (Costco generates approximately $125 million per warehouse in sales to Sam's $70 million.)
That leaves a spinoff as the most likely deal structure, where Wal-Mart gives every current shareholder a piece of the new entity. This would enable shareholders to decide for themselves whether they want to own Sam's Club as a stand alone business. In particular, it would give the Walton family, which owns a big chunk of the shares, more flexibility in where they want those billions invested.
Extricating the elephant
It would seem like a relatively straightforward process to extricate Sam's Club from the rest of Wal-Mart. As discussed previously, buying and distribution are largely separate already. Back-office systems would need to be extricated, but with Wal-Mart's legendary IT prowess, this is probably not an overwhelming obstacle.
The management team is partially in place, although Sam's Club is currently run as a division of the company, so it doesn't have chief executives with experience running a standalone company. Doug McMillon, the CEO, is a very capable merchant who grew up on the Wal-Mart side of the business. In the retail world of today, the necessary executives could be found, perhaps from within Wal-Mart's deep management bench itself.
Sam's Clubs outside the U.S. would probably not be part of the deal, since they are run by the international division, with day-to-day operations managed by the in-country teams in Mexico, Brazil, China, Canada, and Puerto Rico.
Conclusions
Spinning off Sam's Club could be the best thing to happen to Wal-Mart in years. Clearly, the company needs to do something to reinvigorate its stock price. It could also be a good thing for Sam's, which has long labored under the shadow of its (much) bigger brother. I would not be surprised if there is a real effort under way in Bentonville to make this happen. Keep your eyes and ears open for future developments.
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Fool contributor Timothy M. Otte surveys the retail scene from Dallas. He welcomes comments on his articles, and he owns shares of Wal-Mart but none of the other companies mentioned in this article. The Fool has a disclosure policy.
