Wal-Mart Continues To Progress

Wal-MartOn January 7th I posted an article about Wal-Mart (NYSE:WMT). Since then, the stock is up 6.8%. The S&P 500 is up 3.0% over the same period. In this post, I outlined the major investments the company is making in its employees and technology. Additionally, I analyzed the competitive environment that the company operates in and why I believe Wal-Mart will be successful. If you would like to read the post, you can find it here.

Since this post we have seen Wal-Mart continue to execute its strategies. On January 15th the company announced that it would be closing 269 stores, of which 154 are in the U.S. Many people were surprised and saw this as a worrisome development. However, I view this as normal operations for a mature retailer. Wal-Mart has over 11,500 stores so it shouldn’t come as a huge surprise that they close a few each year. As an investor, I like to see management focusing on effective operations and closing underperforming stores. These store closures only account for about 1% of total revenues. The real information in these store closures was that Wal-Mart decided to close down the Wal-Mart Express stores. These were small size stores that mostly competed with Dollar Tree (NASDAQ:DLTR) and Dollar General (NYSE:DG). These small format stores were not profitable and targeted urban areas. Personally, I think this was a good business decision. As large as Wal-Mart is, this was more of a trial run to see if this concept would be effective. I don’t think it fits in with the long-term strategies of the company.

Store Productivity


One of the best retail turnarounds since the financial crisis was at Home Depot (NYSE:HD). This company took a huge hit after the housing bubble burst and CEO Frank Blake did a terrific job turning the company around. The stock went from $29 in August 2011 to north of $130 today. I think it is worth noting the strategies that were so effective for Home Depot and comparing them to Wal-Mart’s today. CEO Frank Blake leveraged three strategies that worked incredibly well:

  1. Reduced store openings. HD went from expanding its store base by 5-6% each year to less than 1% each year.
  2. Management focused on store productivity. Sales comps and traffic continually improved along with margin expansion.
  3. Capex dollars were shifted to buying back shares

When I used this as a case study, I noticed many similarities between HD then and WMT today. Wal-Mart seems to be focused on creating a better shopping experience by improving inventory management and customer service. They are investing in their employees by boosting wages and increasing training so employees can offer a better customer experience. Employees are receiving more training than they ever ranging from customer interaction to using new technology. Traffic and sales comps continue to be positive with traffic up 0.7% and sales comps up 0.6% in Q4. The company is focused on running existing stores more efficiently and closing those that are not productive. Wal-Mart also continues to buyback large amounts of stock. They will purchase $2 billion in stock over the next two years. I think these strategies will prove to be successful.

E-Commerce


Many analysts are disappointed with the growth of Wal-Mart’s online presence. However, Wal-Mart is actually growing its online sales at about the same pace as Amazon (NASDAQ:AMZN) did when it began online sales. Investors think that Wal-Mart should be growing its online sales as fast as Amazon or it is a failure. I would disagree with this assumption. First, the infrastructure must be built in way that will be highly profitable for Wal-Mart. I think people forget that Amazon still doesn’t make money. WMT continues to build fulfillment centers around the world and is continually improving its online platforms. About 70% of online sales in Q4 were executed on a mobile device. WMT grew ecommerce sales by 12% in FY 2016. The ecommerce industry is growing at about 16% but expected to have a 12% CAGR into 2020.

Analysts and investors widely believe that Amazon has taken a lot of business away from Wal-Mart. However, about 56% of Wal-Mart’s sales are grocery and I know that I am not buying milk and bread on Amazon. I don’t know anyone that is. Wal-Mart’s grocery business is actually thriving with Neighborhood Market comps up 7%. I will admit that Amazon has taken a small amount of business away but I don’t think it is anywhere near what people are estimating. The major battleground over the next five years will be online grocery and grocery delivery. We are beginning to see this trend develop however it is certainly not a widespread phenomenon. I think people are underestimating the power of WMT. The company can absolutely compete with any other grocery delivery service just by using the existing stores as warehouses. I don’t think it would be difficult to have employees fulfill online orders and deliver them quickly. Even within two hours for most customers. I believe this is the direction the company is heading and I think it is probably the only retailer that can beat Amazon. In Q4 WMT announced that is saw a 46% increase in Sam’s Club grocery pickup which is the fastest growing part of the business. Customers are beginning to experiment with online grocery but 93% of grocery sales still occur in brick and mortar stores. Here is breakdown of a survey performed by Cowen indicating potential online grocery sales by demographic.¬†Grocery sales

It is not surprising that the younger demographics are driving the change. I think we are a few years away from a point when 35-40% of all grocery are executed online. I think Wal-Mart will be in an excellent position to compete with Amazon for this business. With the amount of potential distribution centers and the massive quantities sold, I see economies of scale working in their favor.

Conclusion


Wal-Mart continues to invest in growth and execute their strategies. The company has now seen six straight quarters of positive comps. As time goes on, more customers will shift to their digital platforms. When customers use digital platforms they are expected to purchase 15-20% more than they would in store. Additionally, as less people shop in stores, it will make for a more pleasant shopping experience for those who still do.

Many analysts fear the company’s contracting U.S. operating margins. However, I believe this is transitory and will reverse once the digital infrastructure is in place. It is worth noting that margins at Sam’s Club and the international segment have been positive in terms of y/y growth in three of the last five quarters.

The stock pays a nice dividend that yields just shy of 3% and the stock continues to trade at a fair price. I think it will take potentially several years to see the company’s digital strategies unfold. I think we will see a lot of things change over the next few years. Customers today are thrilled about being able to pick up their groceries without getting out of their cars. Just wait until they won’t even need to drive to the store to pick them up. I think investors have a lot of things to look forward to with this company.

Understanding S&P 500 Earnings Estimates

Analyst Est

Q4 2015 earnings are almost finished being reported and they were fairly disappointing overall. Revenues were down 4.5% and earnings down 8.4% (on non-GAAP numbers). Once again, we watched sell side analysts have to revise their earnings estimates after being overly optimistic. But how optimistic are they about future earnings? I’ll answer that and explain why I have a problem with their earnings estimates.

Generally Accepted Accounting Principles (GAAP)


Generally accepted accounting principles (GAAP) are a set of principles that U.S. companies must use to compile their financial statements. The Financial Accounting Standards Board (FASB) issues a codification of accounting standards that companies are required to follow. These standards are meant to ensure that financial statements are consistent and comparable for investors. Most companies have found that there are certain accounting standards that negatively impact their company’s “true earnings power.” These companies will disclose a non-GAAP earnings per share in their financial statements in an attempt to show investors what they believe are the real earnings of the business. These non-GAAP earnings are sometimes helpful if there are one time items that impact earnings. However, many companies will disregard fundamental accounting like revenue recognition standards in their non-GAAP earnings. They will paint the rosiest picture they possibly can for current and prospective investors. I will give a few examples of some offenders.

Sell Side Analyst S&P 500 Estimates


When sell side analysts estimate S&P 500 earnings, which do you think they use? You guessed it, they use non-GAAP earnings. This isn’t a big problem if the variance between GAAP and non-GAAP earnings is small. However, currently the difference between the two is wide. Really wide. 2015 GAAP earnings per share (EPS) was $91.46 vs. non-GAAP of $117.92. This is the largest variance since 2008. See chart below:S&P PE GAAP non GAAP

Many people believe the market is trading at a P/E ratio of about 17. The only problem is, the earnings used in this calculation are non-GAAP or “fantasy earnings.” In reality, the market is trading at a P/E ratio north of 22x on a GAAP basis. The mean P/E over the last 100 years on the S&P 500 is 15.1x using GAAP EPS. It is important to note that these ratios are not predictive of short term market moves. They are more predictive of long-term future market returns.

Non-GAAP Earnings


Non-GAAP earnings serve a great purpose to investors when used properly. Today, this metric is widely overused with 88% companies in the S&P 500 disclosing it. Even more worrisome is that 82% of the time the adjustments increase net income. This metric is seen as a way for some companies to juice up their numbers. Lets take a look at Tesla (NASDAQ:TSLA). They have decided to disregard revenue recognition standards in their non-GAAP earnings. They enjoy recognizing all of the fees from the life of a car lease up front instead of the amount the customer has actually paid. They also like to play with the expense side of the income statement by not accounting for stock based compensation. These are the two large adjustments they make. However, it looks like there are five more that are smaller. The Q4 2015 GAAP net loss shrinks from $320 million to $114 million on a non-GAAP basis. During the Q4 2015 earnings presentation they announced they believe they can post a profit in Q1 using non-GAAP numbers.

One of the worse offenders is LinkedIn (NYSE:LNKD). LinkedIn also does not account for stock based compensation in non-GAAP earnings. Additionally, they choose to not amortize the intangible assets they have previously acquired. These two adjustments swung their GAAP net loss of $8 million to a non-GAAP profit of $126 million. This company has been doing this ever since they IPO’d. They have never consistently made money. It is anyone’s guess if they ever will. I have my doubts. However, they will continue to muddy up the waters for investors as long as they can.

Q1 2016 And Full Year Earnings


Q1 2016 earnings estimates have drifted lower for many months now. See chart below. Change in S&P 500 Earnings

Even as the overall market has rebounded 11% in the last four weeks, earnings estimates have continued to drop. As of today, Q1 2016 earnings are expected to be down 8.3% YoY. However, full year 2016 earnings estimates remain elevated. See chart below.

Quarterly Earnings EstimatesIt is evident that Q1 2016 earnings are expected to be horrible. Just in the last two weeks, Q1 estimates have dropped from -7.6% to -8.3% while the market has rallied. The amazing thing about this chart is the dramatic bounce in the second half of the year and into 2017. In Q3 2016 and Q4 2016 it expected that earnings grow 5.0% and 9.2% respectively. That will be quite the turnaround considering the -8.3% drop we are expecting in Q1. We will see if this materializes.

Conclusion


It is a complicated time to be an investor. I do my best to always keep an open mind. I continue to look for undervalued companies even though I believe the broader market is on the expensive side. In the meantime, cash is always a position. I am certainly not as bearish as many others. I think there are a lot of people out there looking for the next “big short” and the bears love to make noise. I’d rather make my own assumptions, stay patient, and wait for my pitch.

 

 

 

 

 

Facebook – Unrealistic Expectations

facebook_dislikeFacebook (NASDAQ:FB) is one of the prominent “FANG” stocks. The stock was one of the best performers in 2015 being up about 25%.¬†Facebook is a social networking company. The company is engaged in developing products that enables users to connect and share through mobile devices and personal computers. Today about 80% of users use the social network on a mobile device. Facebook offers various platforms for people to share their opinions, ideas, photos and videos, and to engage in other activities. The Facebook umbrella encompasses Facebook, Instagram, Messenger and WhatsApp. Messenger is a mobile-to-mobile messaging application available on iOS and Android phones. Instagram is a mobile application and Website that enables people to take photos or videos, and share them with friends and followers. WhatsApp Messenger is a cross-platform mobile messaging application and allows people to exchange messages on iOS, Android, BlackBerry, Windows Phone and Nokia devices.

Total Addressable Market


The company announced last quarter that it now has 1.6 billion monthly active users (MAU’s) on its flagship platform. This is a staggering 23% of the entire planet’s population. The world population today comprises approximately 7.2 billion people. Of this total, six billion people fall with within the ages of 10-89 years old. These six billion could be considered to be potential users of FB.

Now, lets take a look at the amount of people within the six billion who live in poverty or extreme poverty. Even if this group is ever given access to a computer that is connected to the internet, they are unfortunately unlikely to add value to FB since advertisers will not pay to display ads. It is estimated that three billion people live on less than $2.50 per day and an additional 1.6 billion people do not have electricity. These are incredible statistics. As far as Facebook goes, we can interpret that Facebook has a total addressable market of about two billion people. As of today, they would therefore have 80% of their total addressable market. I think that it is reasonable to assume that growth in users will be challenging going forward. Here is what Facebooks MAU growth looks like today:

FB MAU

Revenue Growth


Analyst expectations for revenue growth remain incredibly euphoric. Analysts expect FB to generate revenue growth of 42.2% in 2016 and average 34% growth per year for the next five years. I think this is wildly optimistic and I don’t see where the growth is expected to come from. The U.S. and Canada is where the company generates the most revenue per user. I think it is reasonable to say that there is an equal probability that in five years, Facebook may have less users in the U.S. and Canada than today. Facebook doesn’t fix any type of problem or issue. If anything, it creates problems and reduces productivity. I think most people who want to be on Facebook in the U.S. and Canada have already created an account at this point. Please see the chart below showing average revenue per user (ARPU):

FB ARPU

It is clear the U.S. and Canada is the most important part of the world for Facebook. The U.S. and Canada generates almost three times as much revenue as the next best region. However, most of their user growth today is coming from Asia-Pacific and Rest of World. The problem is, these regions are the two worst ARPU producers. I wouldn’t expect this to change dramatically going forward because this metric is driven by advertisers and how much they are willing to pay to advertise. Advertisers are aware that the U.S. and Canada is the best place to advertise and they are not going to pay to advertise to the Rest of World region if they can’t sell products. Once investors realize the U.S. and Canada is a very mature market and will be challenged going forward, the valuation of the company might be dramatically reduced.

Facebook’s Video Problem


Facebook announced last quarter that over 100 million hours of video per day is watched on its site. Over 500 million users watch video on FB each day and over 8 billion videos are viewed per day. Mark Zuckerberg said last quarter that video will be very important going forward. But where are these videos coming from? Most of the videos are being stolen from YouTube and other content creators then uploaded to Facebook. Last year, 68% of Facebook’s top video content were stolen videos from other sites that did not give permission to have their video on Facebook. This equates into 92% of all the video views. Stolen videos are actually preferred in Facebook’s algorithms because they receive more views and they keep people on their site for longer. When content creators are made aware that their video has been stolen and posted to Facebook, they are forced to go through a difficult process to report the stolen video. Only after this will FB investigate. Often times, it can take several days for them to respond to the content creator. In these few days, the video will have gone viral and received most of the views that it will ever receive while on FB. Sometimes Facebook will respond by taking the stolen video down but often times they will do nothing. They will instruct the content creator to ask the person who stole the video to take it down. An example of that is shown below:

FB freeboot

It is not surprising that Facebook is so relaxed about this since they are making billions in revenue off of these stolen videos. This screenshot above was what YouTuber Ethan Klein received from Facebook several days after one of this videos was stolen.

I believe that this practice is unsustainable for Facebook. I think there is a high probability that litigation is coming soon. Either from the content creators or from Alphabet (who owns YouTube). Facebook will have to make a content ID system that prevents copyright infringement. This could hurt them badly. Not only will their metrics take a big hit but also the user experience will be drastically affected which could cause people to leave the platform all together.

Valuation


The company’s valuation has always been astronomical. However, they have done an extraordinary job running the company and outperforming even the most optimistic estimates. It seems like these type of stories never end well. Eventually growth will slow and the company will miss estimates. At that point, the valuation will come down to earth.

FB Valuation

It seems like investors have decided to ignore the expensive valuation and analysts are in love with the stock. Out of the forty nine analysts covering the stock, forty four have it rated as a buy and only one as a sell. The expectations are high and if the company can’t perform, the stock might take a hit. It seems like the stock is priced for perfection and the catalyst of the stock getting an analyst upgrade is pretty much off the table.

In the above valuation, the inputs used are much lower than those used by analysts. Current estimates expect the company to growth earnings at 32.3% per year for the next five years. My normal growth estimate for the same time period is 15% per year. I think this is a more realistic figure. Based on the trailing twelve months earnings of $1.30, the company trades at a whopping 81x earnings. Using the Graham valuation formula, I reached a per share value of $68.25 which is in line with the median value of my valuations. The median value suggests that the stock might be overvalued by approximately 34%.

Conclusion


Facebook’s management has executed near perfectly ever since the stock became public. However, it seems like the interest of its users is video and FB does not have high quality video content. I think it is only a matter of time before there will be litigation regarding theft of content being posted to FB by users. Without these stolen videos, the Facebook user experience may deteriorate. This problem coupled with the total addressable market and average revenue per user issues makes the stock potentially toxic.

Disclosure


No position