Walmart's stock has risen over 25% in the last 6 months. This has been hugely surprising to analysts, with the company surging past most sell-side estimates. The retail giant has recently been facing several well-publicized headwinds, which seem to be having to bearing on its stock price. These are wide ranging, and have dogged the rest of the sector, with the stocks of comparable firms like Costco and Kroger underperforming dramatically.
This starts with competition, both online and conventional. Several cutthroat European chains have begun making aggressive inroads into US markets. Grocery chains Lidl and Aldi are household names in Europe, and have demonstrated that they're willing to loss-lead to build their presences in the US. Existential fears from the spread of Amazon and its cannibalization of consumer retail have also severely impacted the sector. Amazon's recent acquisition of Whole Foods sent many of Walmart's competitors's stock into tailspins, but had no long-term impact on Wal-Mart stock. Can Walmart continue to outperform its peers? Or is this a short term blip before it reverts to the mean?
SumZero member Ritin Patel published a short on the company on 9/18. Patel has been following the company for years as a hedge fund analyst, and we sat down with him to hear his thoughts.
Luke Schiefelbein: What about Walmart initially caught your eye as a value investor? How long have you been following the stock?
Ritin Patel: What initially caught my eye on Wal-Mart was its seeming immunity from the battering experienced by its competitors such as Target and Kroger’s. I’ve covered the broader consumer sector for a number of years and with the market’s infatuation with Amazon and the entrance of the German deep discounters and oncoming price wars in grocery, I have an inclination that this may be the first point in Wal-Mart’s history where its core competency of offering “the best brands at the lowest prices” was under threat. Furthermore looking at the company’s ROE, it had fallen from 21% in 2012 to 16% in 2017 and yet the market rewarded the company with a higher multiple. Based on this point and the fact that there was a high chance of margin erosion in the next few years, the opportunity for a short seems quite evident.
Schiefelbein: What is the market missing here? Could you run us through your thoughts on conventional competitors (i.e. Sam’s Club, Costco)?
Patel: When thinking about what the market is missing, I like to first think about what are they banking on. The story for the Wal-Mart bulls is built on two drivers: 1) positive comp store sales growth and more specifically positive traffic growth and 2) large growth numbers in the online business headlined by the likes of jet.com. The market is essentially pre-occupied with the top-line and is willing to give the company the benefit of the doubt that over time the dilution to the bottom line will reverse trend and become accretive. With lower cost and even lower margin players such as Aldi, Lidl, and Trader Joe’s on the physical front and behemoths like Amazon on the online front, I take an anti-consensus view that sub 7% EBITDA and sub 4% EBIT will be the trend and revert closer to more global averages in the low 5% EBITDA range for the sector as a whole, resulting in a lower multiple and hence lower stock price.
Schiefelbein: Would the entry of an activist help or hurt long term shareholder value? Why?
Patel: I think an activist would be highly valuable to the business but at the stock’s current valuation, it would be wiser for an activist to wait for the 3rd and 4th quarters to play out in what I think will be a very challenging holiday season, have valuations potentially re-rate lower, and then enter. Activists have played an important part in the de-conglomeration trends in the market and I think that’s what Wal-Mart needs. The business really expanded in the 90s on the back of Supercenters and greater power over suppliers and they need to back to those basics in order to maintain market share. An activist will see this and they’ll also see a relatively healthy balance sheet that can be supplemented by selling poorly performing international assets. The U.K. business Asda has been a constant challenge as it has given up a lot of market share to competitors such as Lidl and Aldi and having an activist come in and push management to sell a challenging business and keep them focused on the core North American Supercenter and e-commerce business would be a great for investors and the firm.
Schiefelbein: What key metrics should investors be paying attention to as your thesis matures? What catalysts would have a negative impact on your position?
Patel: The most important metrics for me are obviously the top-line numbers, so comp store sales, the breakdown between traffic and ticket growth, EBIT margin, and long term EPS growth. From the color management gives investors around long-term EPS growth, we can start to put a picture together of how confident they are in being able to weather price deflation and get back to some level of margin accretion in the future. For me, the metric I’m keeping my eyeballs glued on is the EBIT margin. It’s the arbiter for how successful the firm investment in price, delivery, employees, and technology end up becoming.
Schiefelbein: What are the biggest risks associated with the trade in your view? How could it go most wrong?
Patel: The biggest risk that I see in the trade is Wal-Mart being able to outmuscle its other physical grocery competitors and take market share from higher cost grocers such as Ahold (Food Lion) and Kroger’s. Another risk would be a slower rate of expansion of the German discounters. The likes of Aldi and Lidl like to build each store from scratch, understand every aspect of the cost and this approach would likely take much longer than acquiring square footage via an acquisition or leasing vacated space. The point on taking market share from traditional grocery incumbents feeds into another source of risk, which is that the industry consolidates and by virtue of having fewer channels to push their products into, CPG companies will feel further pricing pressure from Wal-Mart.
Schiefelbein: What are your thoughts on the Jet.com acquisition? Can Walmart compete with Amazon and other online retailers? How directly does Walmart compete with Amazon?
Patel: Jet.com is compelling as an intellectual exercise but I don’t see the tangible returns that management expects to be delivered from the company. The concept of delivering customers greater savings as they purchase more product through the company’s pricing algorithm sounds interesting but ultimately offers needless complexity that consumers simply won’t bother to go through. How do I know this? Look at the success of Amazon’s one-click system or any Apple product for that matter. Consumers simply want to know they’re getting the lowest prices and are having the product delivered to their doorstep as cheaply as possible, which to most consumers means "free" shipping. Furthermore, having two sites in jet.com and walmart.com competing against Amazon just seems unnecessary. When asked for color around the breakdown of growth between the two sites, management sidestepped the question and gave vague guidance around profitability, which tells me that Jet.com continues to bleed with no real end in sight. Behind the façade of a complete omni-channel presence, I take issue with how they’ll be able to compete with the simplicity and proposition of Amazon Prime. Amazon’s expansion into packaged foods and household products puts it further into competition with Wal-Mart and the what’s even more challenging is that we’ve seen a lot of consumer companies from General Mills to Nike selling more product on its website. It’s enough to change the tone of Wal-Mart’s conversations with suppliers who aren’t simply going to sit back and take price reductions knowing there’s this huge online channel where they can sell into.
Schiefelbein: Could you walk us through the impact of one of Walmart’s competitors acquiring a smaller discount retailer?
Patel: After Amazon’s acquisition of Whole Foods, I wouldn’t be surprised to see more consolidation in the industry. Given the vast geography of the country among other factors, concentration in the grocery business is lower than in other countries such as the U.K. We could potentially see Sprout’s getting acquired by Albertsons and I think someone could acquire a Dollar General or a smaller discounter such as Five Below. It would be a great way to acquire cheap store space in rural areas where there is less competition and lower income consumers who generally purchase more private label product.
Schiefelbein: Are shifting consumer demographics a headwind or tailwind for Walmart? Why?
Shifting demographics continue to be a headwind for the company. I think they’ve tried to address this with some of their acquisitions in online such as Bonobos, Modcloth, and Jet.com which skew to a younger demographic. Ideally as a retailer, you want a loyal consumer base that are starting to form households as they will be the foundation for the next two or three decades of revenues for the company. Wal-Mart had that core base in the 90s and into the first decade of the 2000s during their strongest growth phase with the Baby Boomers. Demographically, Baby Boomers are the largest consumer base for Wal-Mart but they also pose the biggest problem. They’re highly brand conscious consumers who will rely more on retirement savings and transfer payments and these qualities simply don’t fit with the changes we’ve seen in the sector. There are really two trends that I think will continue to do well among Generation Y and Millennials and that Wal-Mart needs to invest more in which is 1) organic and fresh offerings and 2) a strong private label.
Schiefelbein: What are Walmart’s biggest problems right now? What is it doing to fix them?
Patel: Wal-Mart’s biggest problem right now is that it simply isn’t doesn’t hold the position of being the lowest cost grocer that it once was. The investor day showed some good improvements in convenience such as being able to order online and pick up in store, scan-and-go technology at Sam’s Club, as well as a number of other initiatives to improve the in-store experience but what got forgotten is that price is the true competency of the company. We know price competition will be stiff so the question of addressing how to prevent margin dilution comes down to two things: 1) negotiating larger price reduction from the CPGs and 2) somehow shifting to a greater private label offering which traditionally has had higher margins. Wal-Mart’s private label is currently running 20% higher than that of Aldi and Lidl and yet investors still have no idea for the blueprint of how the company can lower that difference.
Schiefelbein: Where else do you see value in the market today?
Within the consumer sector on the long side, I’m looking at Ralph Lauren and Coty as potential self-help stories. The draw to each of these names to me are well established brands or a portfolio of brands in the case of Coty and the level of execution risk already built into the price for both these names. Sourcing shorts has become much harder consider the entire sector has re-rated but with consolidation still a strong theme especially in CPG, there are a few names that look a bit overhyped right now.