Walmart (WMT) remains an interesting story to watch, not just as bellwether for the US economy, yet furthermore because is it one of the few companies which has fair shot to compete against the likes of

Late February I last looked at the shares as I concluded that the company sees continued growth and continued margin pressure, as this was just day ahead of the full outbreak of the Covid-19 crisis, causing both a lot of uncertainty and provided a boom to the first quarter results.

The Thesis

Walmart just reported its 2019 results late February and despite a softer end to the year, shares continue to trade at elevated levels around $116 per share. I noted that investors apparently seem to like the strategy of sacrificing margins in past years to boost sales growth, creasing a real formidable competitor to the giant in Seattle, as Walmart has created real e-commerce capacities as well.

For the year of 2019, Walmart reported sales of $524 billion, up 2% on the year before. All of this growth was pretty much explained by e-commerce growth, suggesting flattish comparable sales growth from the actual stores. With e-commerce sales up 35% year-over-year, I estimated the e-commerce contribution to total revenues at around 8%. While this percentage is small, that suggests a +$40 billion e-commerce operation, of course assuming e-commerce penetration is achieved across the globe.

The company reported adjusted earnings at $4.93 per share as the company ended the year with $40 billion in net debt, with that number excluding $22 billion in financial and operate lease liabilities. Despite the sales growth, margins were down with operating profits falling 6% to $20.6 billion, making that operating margins fell to 3.9%, far below the range at 5-6% reported in the decade leading upto 2019. Nonetheless, a $32 billion EBITDA number provided a great deal of financial power to manage a relative modest net debt load.

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For 2020, the company expected sales growth at around 3% as adjusted earnings per share were seen up by around 3%, seen around $5.00-$5.15 per share. This suggests some modest margin pressure as share repurchases most likely would be responsible for the majority of the expected earnings per share growth.

With sales growth seen up low single digits the outlook essentially revealed some expected further margin deleverage. Trading around $115 per share, shares traded at 23 times earnings which is a steep multiple given the modest growth.

The positive, or potential for Walmart would be the company returning to even the lower end of the 5-6% operating margin range, which the company achieved in recent years. Even if the company would return to the lower end of that range, operating earnings of $27 billion would translate into earnings of around $6.50 per share. If achieved, this $1.50 per share boost to earnings would reduce valuation multiples to about 18 times earnings. That said, achieving a point improvement in operating margins is a daunting task.

The reason for that is that continued growth in e-commerce (which is a lower margin business) furthermore comes alongside the fact that sales of the stores are flat at best, a trend seen by many omnichannel operators. Hence, I believed that 3-4% operating margins were the new norm, not 5-6% as was seen in the past.

The Start Of The Year

The first quarter for Walmart was a very eventful one of course given the Covid-19 impact, really starting to make an impact in March. The company reported very strong first quarter results with Walmart benefiting from formidable e-commerce capabilities as the fact that is stores remained open, being labeled as essential, even as it sells many non-essential items.

The company reported first quarter comparable sales growth of 10.0% for the US Walmart operations, as e-commerce sales were up 74% for Walmart US, yet of course growth was driven by the back-end of the quarter. Growth at Sam’s Club came in at 12.0% on a comparable basis, which is impressive as e-commerce sales were up ¨just¨ 40% and the unit saw a 410 basis point headwind from tobacco sales being ended. International sales were up just 3.4% yet that is a bit misleading with currency headwinds reducing sales by about 4 points as the company furthermore reports international sales with a month lag, a key factor in this environment.

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We know that Walmart US e-commerce sales were up 70% and added 390 basis points to reported sales growth. On a total quarterly revenue base of nearly $89 billion for the main activities, that suggested that 70% growth added nearly $3.5 billion in sales, revealing about $8.5 billion in sales are derived from e-commerce activities, nearly 10% of sales.

The combination of spectacular sales growth and margins pressure, in combination with very modest share buybacks, resulted in adjusted earnings per share growth of five cents to $1.18 per share. The additional earnings and retaining them makes that net debt has been reduced towards $38 billion.

Investors anticipated a benefit from the hoarding effect as shares rose to a high of $132 in April, before now settling at $125. With investor recognizing that sales growth is not really translating into earnings growth with margins under pressure due to increased e-commerce sales and the company, incurring quite a few costs to allow for a healthy working environment and additional wages (about three quarters of a billion in the quarter), investors seem to realize that too much optimism might be a bit early.

This inherent uncertainty, not just on the virus, sales, and margins, makes that management has furthermore withdrawn the guidance for the year, yet that is not necessarily a negative.

A Cautious Stance

Shares of Walmart have done well in recent years driven by its success in e-commerce, yet that same trend is hurting margins a great deal, and this trend will only reinforce itself in this current environment. While the current changing times confirm that Walmart does well in almost any scenario, including anticipated tougher economic conditions, valuation multiples come in around 25 times earnings here.

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This is a very high multiple for a company which is already among the largest in the world while it sees continued margin pressure. On the other hand, the very low interest rate and leadership position in any environment makes it compelling, that is only driven by the framework in which interest rates are so low.

Amidst all of this I am far from comfortable holding a position here, although the sheer size and capabilities make it a very dangerous company to bet against. Nonetheless, I feel that shares have been given a little too much the benefit of the doubt and while Walmart is and will remain a dominant player, I would not rule out continued pressure on margins. While e-commerce makes the company remain very relevant, actual store sales are flattish at best, making a medium term outlook for continued margin pressure most likely, and hence it makes me cautious on the near to medium term outlook for the shares.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.