Walmart: All About The Margins (NYSE:WMT)

Towards the end of July I concluded that I was not ringing the register yet on shares of Walmart (NYSE:WMT). The company was seeing the initial struggles with inflation and while development boosts sales, overall it is a negative for the business as it hurts margins and volume growth prospects.

With near term earnings power being poor and uncertain amidst a massive inventory glut, earnings estimates have been cut by a dollar per share from the initial numbers. This makes that share price declines in 2022 have been more a reflection of reduced earnings, rather than reduced earnings multiples being applied to the business.

A Small Recap

The look at Walmart starts with the 2020 results which were reported early in 2021. Revenues rose 7% to $559 billion with growth driven by the pandemic, as operating earnings rose 10% to $22.5 billion. Operating margins of 4.0% fell short compared to the long-term range, with margins traditionally having come in between 5 and 6%. These margins and a $5.48 per share number left upside if the company could boost margins, a huge and multi-year task of course in a very competitive environment.

After a strong 2020, investors and the company believed that 2021 could become a year with tough comparables, yet the company actually managed to boost margins to the mid-fours (following the Asda divestment) and lapping of some Covid-19 related costs, as the company ended up growing 2022 sales by 2% to $572 billion. Operating earnings rose to $26 billion, for margins of 4.5%, as earnings came in at $6.46 per share, a dollar ahead of the 2020 results.

With very modest sales and earnings growth seen in 2022, shares had seen quite some momentum, trading around a high of $160 in April of this year, at a 24-25 times multiple, albeit amidst very moderate leverage with net debt trailing operating earnings.

Some Weakness

Shares of Walmart fell to $130 in May. While 3% revenue growth for the first quarter of 2022 looked reasonable, adjusted earnings came in a touch light at $1.30 per share amidst inflationary pressure, supply chain issues and higher labor costs. Furthermore, inventories rose from $46 billion to $61 billion (annually) being a clear sign of an inventory buildup.

In July, the company announced next profit warning, triggering a pullback to $120 per share. While Walmart hiked the full year sales guidance to 5.5%, that was driven by inflationary trends. Consequently, the company sees operating earnings down 11% this year, with margins seen down to 3.9%, as earnings are now seen between $5.80 and $5.90 per share. With earnings cut by almost a dollar since the initial outlook for 2022, the move in the share price really matches the cutback in earnings estimates, rather than a different multiple being applied to 2022 earnings.

I must say that after hitting a low at $120 late in July, shares have recovered quickly and have mostly traded in a $130-$140 range ever since. Part of the reason is that the second quarter results, released in August, were quite okay with revenues up more than 8% to $153 billion. Adjusted earnings of $1.77 per share were down a penny compared to the second quarter of last year as the true extent of margin pressure was not yet seen.

Net debt inched up to $32 billion following working capital changes (higher inventories) and larger organic investments into the business. Inventory balances are up some $12 billion to nearly $60 billion year-over-year, indicating that the worst of the built-up in inventories might already be a thing of the past. Despite intensifying currency headwinds, the company maintained the guidance for the year, a comforting sign.

And Now?

With the passage of time, we see Walmart now trade at a 22 times multiple based on this year’s earnings, still a huge multiple given the developments in the wider stock markets. This is to be achieved with margins sub-four percent as this is the problem, yet the opportunity as well. If margins would only reverse to 5%, it could boost earnings by one and a half dollar. In such a case, once achieved, earnings multiples would fall from about 22 times earnings to about 17-18 times earnings.

Furthermore, there is another recent move which has implications for the business and industry at large: the tie-up between Kroger (KR) and Albertsons (ACI). This deal will grow Kroger’s sales by some 50% to about $210 billion, equal to about 35% of Walmart’s revenues here, albeit that Walmart of course has large overseas operations.

Investors in Walmart are apparently not impressed with the deal, not seeing a major competitive threat as shares fell 1.5% in a downbeat market, with shares starting the day around the flat line. The issue is that I still remain cautious on Walmart even as the second quarter earnings report should inspire some confidence. Current earnings multiples remain high, net debt inched up a bit, and the company is furthermore involved with minor opioid settlements as well, all not very positive signs.

With markets themselves seeing quite some turmoil, I am surprised to see the continued outperformance of Walmart. While of course it has a great long term track record, I remember that shares could be bought for years at a discount versus the wider market. Right now, it feels a bit rich despite the safety of the track record and scale of the operations.

While the Kroger & Albertsons deal is not a game changer for the industry, as Walmart might even benefit from some management distraction at Kroger, I am cautious as I do not see a sustainable path to historical margins of 5-6% here, badly needed to see real appeal in the shares of Walmart.