Archive for October, 2009

Wal-Mart: Hold Long-Term and Write Covered Calls

by Mat Overbaugh, Rob Weigand and Zach Wilson.

Our last recommendation, which was to go long Procter & Gamble (PG) on August 30, has outperformed the S&P 500 by almost 4% over the past month. Today we’re going to review another “high-quality” stock that has not fared so well over the same time horizon: Wal-Mart (WMT), which underperformed the market by about 10% in September 2009.


Interestingly, Goldman Sach’s August 24-2009 Hedge Fund Monitor listed both PG and WMT as “Hedge Fund VIPs,” with 22 funds having WMT amid their top-10 holdings and 14 having PG as a top-10. We’re going to disagree with hedge funds’ positive outlook for WMT, however. Bottom line of this analysis is that if you don’t own WMT, don’t rush out and buy it. If you do own WMT, it’s acceptable as a long-term “hold,” although you should periodically coax a little more return out of the position by writing covered calls — starting now with the Jan-2010 $52.50 calls. Although WMT models up as financially stable and fairly valued, we can’t foresee any news catalyst that would get the market excited about this stock. WMT has gradually become compartmentalized into the same “no-catalyst” category as high-quality stocks like JNJ (although WMT earns than half JNJ’s return on invested capital). Writing covered calls 2-3 times a year should add 3-5% per year to this low-return position. And, if the calls you write suddenly lurch into the money and your WMT shares are called away . . . that probably won’t be a bad thing for your portfolio in the long run.

The table below shows the key assumptions we used in forecasting WMT’s financials and our discounted cash flow valuation model. The main forecast “stressor” we employed was slower revenue growth than the analysts’ consensus of 11.9% over the next 5 years, which is, in our opinion, a number that bears little relation to reality. WMT grew revenues at an average pace of 9.3% from 2005-2009; they even grew a respectable 7% in 2009. But we’re forecasting 2-3% growth in 2010, 3% in 2011, and 4% thereafter. Our model can therefore be interpreted as a slightly below-average scenario for WMT, which we think is entirely possible given the ruthless competition the discount retail space is known for, and greater-than-expected resistance to their overseas expansion plans that we foresee as they try to adapt their model to different consumer cultures.

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We also increased WMT’s beta to 0.6 from their historical 0.2 — extremely low (and high) betas are known to revert closer to 1.0 in subsequent periods. Moreover, WMT’s beta of 0.2 resulted from the stock being an immutable, if not inert, force in the market over the past 5 years. We tapered their dividend growth rate as well, expecting that their plans for international expansion will consume a bit more of their free cash flow than their US expansion required.

WMT’s relative valuation is comparable to that of TGT based on their P/E ratio —


Price to cash flow ratio —


And price to sales ratio.


WMT’s EPS and DPS display reliable historical growth; our forecasting model indicates that this growth is sustainable and likely to continue in the future.


One reason WMT has been unable to grow shareholder value (the stock has matched the S&P 500’s return over the past 5 years) is its low operating and net margins. These are stable historically, and forecasted to remain stable.


WMT’s ROIC, ROE and ROA (return on invested capital, equity and assets) are also much lower than other high-quality stocks, such as PG and JNJ. WMT’s ROE has been gradually declining over the past 5 years. Our forecasting model indicates this is likely to continue. Their ROA of 8-9% is unexciting and unlikely to grow in the future.


WMT’s NOPAT and Free Cash Flow (FCF) have also grown steadily in recent years. Our model indicates that future FCF generation will probably slow as their international expansion plans result in a less efficient deployment of capital than their multi-decade US expansion. This is another factor that will make it challenging for WMT to grow shareholder value.


Not surprisingly, growth in WMT’s Economic Value Added (EVA) is also forecasted to level off through 2014, in sync with their slower FCF generation.


WMT does not score as highly on the 11-point Piotroski Financial Fitness Index as other high-quality stocks like JNJ and PG . . .


. . . although their Altman probability of bankruptcy scores are solid historically and on a forecasted basis.


Short sellers have never taken great interest in the stock. Short interest has subsided recently . . .


. . . and their days to cover ratio is a reasonable 2.0.


WMT’s low beta is probably the best reason to consider holding the stock. Its low volatility and low correlation with just about everything make it desirable from a risk-management standpoint, although its low expected return and low dividend yield (2.2%) make it an unexciting investment, and thus a good candidate for a systematic covered call strategy.

Categories: Market Commentary