Bad News From Bentonville
Last Wednesday, Walmart shook up the market with a surprising announcement regarding future earnings. The retailing empire based in Bentonville, Arkansas, stunned analysts and investors with their forecast of a 6% to 12% drop in earnings in fiscal 2017. According to Bloomberg, analysts had been expecting a gain of around 4%.
Investors reacted strongly to the news. Walmart stock dropped 10% for the day, its largest single-day drop in over 27 years. The entire Dow Jones Industrial Average dropped almost 1%.
Walmart's bad earnings forecast maintains their recent negative momentum. Disappointing second quarter earnings had already caused one downward revision. For the past year, Walmart stock is down a staggering 30%, wiping out $83 billion in shareholder value — $21.5 billion on Wednesday alone. At the current rate of decline, this will be Walmart's worst year for stock values since 1973.
Attempting to ease stockholder pain and bolster stock prices, Walmart announced a $20 billion stock buyback over the next two years. It remains to be seen, however, if this move will staunch the current stock slide.
Is this pessimism warranted or just a knee-jerk reaction to a market that is completely focused on growth? To answer that question, it's important to look at the reasons behind the lower earnings forecast.
Rising Costs in the Short Term
Walmart's recent worker investments share some of the blame, given their minimum wage increase to $9 per hour and the $10 per hour increase scheduled for 2016. They have also invested more in employee training, which is arguably overdue — much of Walmart's problems at the customer level are related to poorly stocked and messy shelves and a perceived decline in customer service. Higher wages and training programs will add $1.2 billion in 2015 costs and $1.5 billion in 2016 costs.
The larger issue is investment to deal with competition, especially Amazon. The e-commerce giant passed Walmart in market valuation early this year and hasn’t looked back. At Wednesday's close, Amazon's market cap was $257 billion compared to $192 billion for Walmart. Amazon's revenue's (quarterly in the $20-$30 billion range) are far below Walmart's nearly $500 billion annual revenue, and Amazon rarely turns a profit compared to Walmart's usually solid profit — yet Amazon is on a clear trend upward while Walmart is headed in the opposite direction.
Sales are expected to finish this fiscal year flat and reach 3% to 4% annual growth over the next three years. Walmart projects an earnings rebound in fiscal 2019 when the returns from these efforts should boost earnings per share by 5% to 10% over fiscal 2018. However, that is dependent on accurate growth assumptions.
Walmart realizes that to take on Amazon, it is going to have to invest heavily in the systems and infrastructure to allow it to compete efficiently in e-commerce. That effort will likely contribute billions to Walmart's overall costs while it executes its strategy.
While investors may be skeptical that Walmart will generate a sufficient return on their investment in e-commerce, CEO Doug McMillon points out that in the long run, it will be easier for Walmart to add digital and supply chain capabilities to their existing brick-and-mortar infrastructure than it will be for Amazon to "build out a massive store network and create a customer-service culture at scale."
Translation: Walmart still has a large component of its sales revenue that it isn't as practical for Amazon to get into without brick-and-mortar infrastructure, such as groceries. Thus, the emphasis on smaller stores, the "Neighborhood Markets." Amazon can counter with partnered delivery services, but that is not a guaranteed success by any means. Walmart has already entered the outside pick-up grocery market in 23 markets, with 20 more slated for next year.
Last year, Walmart opened 354 stores in the US. They are slated to open only between 135 and 155 stores in the next fiscal year, and Neighborhood Markets make up the largest share of new openings within both years.
The Long Reach of Walmart
The average American may not even be aware how much Walmart affects his or her holdings. Many of the most popular index funds have Walmart stock as a component. Consider that Walmart accounts for around 2.3% of the weighting in the Dow Jones Industrial Average, thus the Walmart plunge sent the SPDR Dow Jones Industrial Average ETF Trust (NYSE:DIA) into negative territory.
The collective Vanguard index funds own 98.6 million shares, making them the fourth-largest owner of Walmart stock. That position dealt Vanguard investors a total $661 million single-day loss thanks to Walmart's announcement. BlackRock and Berkshire Hathaway were not far behind at $573 million and $405 million in losses respectively.
Whatever your personal losses on Walmart stock might have been last week (if you own any), you can take solace that you aren't a Walton family member. Their collective single-day loss was just over $12.1 billion!
Walmart certainly got investors attention with their earnings forecast, and Amazon and other rivals do pose serious challenges to their business. However, not all investors are ready to throw in the towel. Amazon may be growing and have a higher market valuation than Walmart, but they are rarely profitable — and for all Walmart's problems, they are a generally profitable mature company. Stable blue-chip stocks at undervalued pricing are usually worth a good look.
Walmart simply is so big that percentage-based growth is limited by definition. They are approaching half a trillion dollars in annual revenue, and there are only so many stores that can be opened. Online sales are the only reasonable place for Walmart to meet growth potential. One could argue that failing to meet this challenge head-on would be trading short-term stock stability for longer-term pain and decline.
As of last week’s close, Walmart stock is trading at a price to earnings (P/E) ratio of 11.7 according to NASDAQ and at around 12-13 based on earnings over the next three years. The rest of the Dow is currently at a P/E of 16.6 with forward estimates of 15.7. Keep an eye on Walmart's stock price and if it meets the criteria for your portfolio and has a P/E ratio that you consider to show significantly undervalued stock, it might make sense to buy. There is nothing wrong with stable growth, or investing in methods to keep that growth moving forward in the face of fierce competition.
Meanwhile, if you don't know what your index fund holdings are, take a few minutes to look them up. It's always good to know what components of your index funds are performing well or poorly, especially if you are thinking of switching. It is hard to make an intelligent decision otherwise.