On January 7th, I posted my first article about Wal-Mart. I posted another on March 23rd. You can read these here and here. Wal-Mart has performed well this year. It is up 19.6% YTD. The market is up 7.1% YTD.
Last week it was announced that Wal-Mart purchased Jet.com for $3.3 billion. What is Jet.com, you ask? It’s a 1-year-old online shopping site selling groceries, furniture, and small appliances. It has some pricing gimmicks, but it’s basically the same old business model: an online marketplace where third-parties source the products and sell directly to consumers.
Wal-Mart’s e-commerce has been a hot topic among analysts for the last 18 months or so. I wrote about their online business in my first two posts. Wal-Mart was expected to spend $1.1 billion this year and $1.3 billion next year on e-commerce. Online sales were expected to grow 20-30% a year which would be consistent with Amazon’s growth. However, last year they fell short of expectations by only growing online sales by 12%. In Q1, they only grew online sales by 7%. Is buying Jet.com the answer? In short, No. I was very supportive of WMT’s e-commerce strategy and investments. I thought they were doing a good job. However, buying Jet.com is a key long-term strategic move for the company and I cannot support it.
Boosting store productivity of an existing retail store is very difficult. You have to create strategies, goals and initiatives that flow throughout the entire business. Most importantly, the employees that are directly interacting with customers must understand and believe that they are the backbone of the business. No one did this better than Frank Blake at Home Depot in 2010. The company had serious productivity issues and he executed one of the best retail turnarounds ever. (I discussed this in my previous article here.) The reason I mention this again is because we are seeing WMT shift away from these proven strategies. At the beginning of the year, Wal-Mart boosted wages for all employees. This worked very well because it improved customer service and Wal-Mart employees purchased more merchandise when they shopped at Wal-Mart.. The other strategies that WMT put in place were to invest in inventory management systems and close underperforming stores. Both of these were good. Finally, they shifted capex dollars to boost the buyback which has been accretive to shareholder value.
Now they are heading a completely different direction. Instead of focusing on improving the customer experience, they are going after a zero margin business. No one is going to stop shopping on Amazon and start shopping on Jet.com because their dish soap is $0.02 cheaper. That isn’t going to happen. If Wal-Mart tries to cost cut Amazon, they will lose.
Now there are two directions that Wal-Mart can go. 1) Keep Jet.com separate from Wal-Mart.com and try to grow it as fast as possible. 2) Integrate Jet.com into Wal-Mart.com and have a Wal-Mart.com powered by Jet model. I don’t know what they plan to do but either one will cost a lot more than the $3.3 billion they already paid.
Merging Businesses and Cultures
Mergers are extremely difficult. Combining two existing businesses and maximizing synergies is complex and time consuming. It requires excellent planning and perfect execution. The fact is, 83% of mergers fail to increase shareholder returns. Most of the time they don’t work. This acquisition will probably not work out well for existing shareholders. Although $3.3 billion is not a lot of money to Wal-Mart. This is just the beginning. They will probably spend another $3 billion in the next two years merging the businesses.
The capital isn’t the only problem. All companies have limited time and attention. Where they spend that time and attention drives shareholder value. Wal-Mart will be spending an immense amount of time and attention on this merger. Time they could be spending on improving their customer experience. Companies get in trouble when they spend 90% of their time on 10% of the business. This is what WMT is doing and this is a zero margin business. The core business is doing very well posting 1.5% comps and 6.5% comps for neighborhood stores. I fear the company will not appreciate how well this piece of the business doing and not give it enough attention going forward.
The Wal-Mart and Jet.com cultures could not be more different. Jet.com has made many moves that sacrifice profit for growth. Wal-Mart is the opposite, they continue to look for ways to boost the bottom line (buybacks, closing stores ect.). Jet.com does not make money and won’t as long as they push for transaction and user growth. Jet.com’s goal is to undercut Amazon’s price which means they are going to have a very difficult time boosting margins. I really don’t know how Wal-Mart will merge these cultures. They are complete opposites.
Wal-Mart’s valuation does not look as compelling as it did when I posted the article last January. The stock is up about 20% since then so that is part of it. Analyst estimates have slightly fallen in the last eight months. Wal-Mart is expected to make $4.91 in FY2019. We know that historically it has traded with a 15 P/E. This gets us to a valuation of about $73.50 which is where the stock is today. I expect revenue growth to accelerate after the Jet.com deal but I think it will hurt EPS.
The bull case is that the stock will demand a higher valuation with the Jet.com acquistion. I wouldn’t be surprised if the stock does get a higher valuation based off of the deal even though I don’t like it. It wouldn’t shock me if the stock trades at a 17 or 18 P/E which would push the stock closer to $80.
Wal-Mart is a large position for me. I bought the stock last November and I have done very well with it. However, I want to own great businesses at reasonable prices. A business that is at war with Amazon sounds like a miserable business. I plan on holding Wal-Mart through November for tax purposes. The Jet.com deal will take months to close and I don’t believe the core Wal-Mart business will be affected in the next 12 months. Looking out over the next 10 years, Wal-Mart is going to be in a expensive fight with Amazon.
I currently hold 35% cash in my portfolio. I have only slightly underperformed the market by 28 basis points through July 31st. Owning companies like Wal-Mart (Up 19.6% YTD), Loews (Up 8.4% YTD), Nexpoint Residential (Up 59% YTD), and Post Properties (Up 12.1% YTD) has helped me. Post Properties was purchased last week by Mid-America Apartments for about $72.50 a share. That deal will close in a few months.
There is a good probability that I will sell my Wal-Mart position before the end of the year. This will take me to close to 50% cash. I continue to look for value one company at a time. It is not easy to find great businesses that are trading with reasonable valuations. I am remaining patient and disciplined. Don’t follow the herd. I am prepared to underperform the market in the short term in order to achieve long term outperformance. Charlie Munger says that envy is the worst human emotion. It is 100% destructive. Being envious that others are getting richer faster than you will do nothing for you. When there is an opportunity, I will be ready.