Wal-Mart (WMT): Can This Dividend Aristocrat Thrive in the Age of Amazon?

Some of the best long-term investments are shareholder-friendly companies that consistently reward income investors with decades of dividend growth.

 

These include such legends as dividend aristocrats and dividend kings, which have been raising payouts for decades in all types of economic and interest rate environments.

 

Let’s take a look at Wal-Mart (WMT), whose epic 44-year history of consecutive annual dividend increases makes it an aristocrat that is well on its way to achieving king status.

 

That being said, whether or not the stock represents a good choice for investors today, especially those looking to live off dividends during retirement, will depend on how management is able to compete with more nimble rivals such as Amazon in the fast-growing e-commerce space.

 

Business Description

Founded in 1945 in Bentonville, Arkansas, Wal-Mart is the world’s largest retailer and operates on a truly staggering scale. For example, its 2.3 million employees (1.5 million in the U.S.) serve 260 million consumers per week in 28 nations via 11,723 stores that cover 59 separate global brands.

 

A little over half of Wal-Mart’s stores are located in international markets, which the company entered in 1991. While Latin America, Brazil, and Mexico are important regions, the majority of Wal-Mart’s sales and profits are derived from the company’s U.S. stores (64% of revenue in fiscal year 2017) and Sam’s Club (12%).

 

Wal-Mart sells just about everything in its stores. Grocery (56% of U.S. sales) is Wal-Mart’s biggest merchandise category, followed by health & wellness (11%) and general merchandise (33%). Wal-Mart has its own private-label store brands, but branded merchandise still represents a significant portion of total sales. The company’s general strategy is to be the low-price leader in its categories.

 

In addition to its significant brick-and-mortar operations, Wal-Mart has fast-growing e-commerce websites operating in 11 countries. Walmart.com averages more than 80 million unique visitors a month and offers millions of products that can be shipped or picked up at one of Wal-Mart’s many physical locations.

 

E-commerce sales account for less than 5% of the company’s total revenue  today but will continue growing in importance as Wal-Mart invests less in new store openings and more in its digital operations, supply chain, and logistics.

 

Business Analysis

Wal-Mart has done a great job of building up a wide moat in a ferociously competitive industry, one with low barriers to entry. That’s thanks to its brand recognition and omnipresence in the U.S., where 90% of Americans live within 15 minutes of one of its stores. Its stores are viewed as one-stop shops for nearly all consumer shopping needs, including groceries which account for over half of the company’s total sales.

 

The company’s sheer size gives it the volume and purchasing power necessary to be a genuine price leader in many merchandise categories, too. Few companies will ever be able to compete with Wal-Mart’s scale and expertise in managing supply chains and product sourcing in the brick-and-mortar space.

 

That being said, Wal-Mart is a classic example of a defensive mega-cap company whose large size is now working against it. That’s because the company’s enormous scale, including $487.5 billion in trailing 12-month revenue, means that moving the growth needle requires large scale, successful execution on the company’s three-year growth plan.

 

 

That plan is built around three components. First, management wants to achieve moderate 1% to 2% same-store growth in existing stores. Next, a gradual increase in global store count, such as its popular rollout of smaller “neighborhood markets” in U.S. cities, is expected to ultimately help Wal-Mart boost top line sales by $45 billion to $60 billion by the end of 2019.

 

Part of this plan is to reinvest into upgrading its stores to present a somewhat more upscale image. Combined with an increased focus on directing its large annual capital expenditure budget into greater employee training, especially in the use of future tech (more on this later), this has helped Wal-Mart turnaround its stagnant same-store sales figures.

 

In fact, after years of steadily falling comps, the company has now generated 11 consecutive quarters of positive, if low, same-store sales growth.

 

 

Next is the company’s plan to compete with e-commerce disruptors such as Amazon (AMZN). This means fostering deeper relationships with customers to better learn their preferences and collect data that can allow Wal-Mart to further optimize its substantial supply chain.

 

To help with this effort, Wal-Mart spent $3.3 billion in mid-2016 to acquire Jet.com, a fast growing online retailer. Since then the company has further expanded its online empire with several more bolt-on purchases.

 

 

In addition, the company is attempting to return to its upstart roots, via the creation of Wal-Mart Labs, a Silicon Valley-based division tasked with finding ways to incorporate e-commerce into its broader business model. This division recently announced Store Number 8, which according to the company “is where wild ideas, impossible notions, and big bets become scaleable realities.”

 

In other words, Wal-Mart is trying to avoid becoming an overly bureaucratized dinosaur by housing innovative and disruptive ideas under its roof, and then giving them access to its massive financial resources to launch on a much larger and faster scale than they could on their own.

 

Only time will tell whether Wal-Mart can achieve this challenging goal of combining its already enormous global reach with an Amazon-like love of innovation and risk taking. However, there are some promising early signs.

 

For example, Wal-Mart online now offers 50 million total items for sale, up from 10 million last year. While this is still far less than Amazon’s 370 million item offering, it does show that Wal-Mart is able to rapidly grow its online presence thanks to a larger focus on becoming a platform for third-party sellers, whose sales soared 69% year-over-year in the most recent quarter.

 

This is the approach that Amazon took and has helped to create enormous network effects; a necessary way for any retailer to build a wide moat and gain market share in the online space.

 

For example, in the most recent quarter, online sales grew an impressive 63% compared to last year’s same quarter growth of just 7%. According to CEO Doug McMillon, most of this was organic growth, which resulted not from the recent acquisitions but the company’s launch of free two-day shipping on orders over $35.

 

This is a direct challenge to Amazon Prime but has proven to be very popular, as has the option for same-day store pickup for items purchased online.

 

 

Meanwhile, Wal-Mart continues to also try to copy the business model of fellow retailer Costco (COST) via its Sam’s Club discounted wholesale chain. That includes a consolidation of 21 private label brands under the new “member’s mark” brand, the equivalent of Costco’s Kirkland store brand. Why copy Costco?

 

Because the wholesale discounted warehouse business model, in which membership fees help offset the razor thin margins, has proven to be a highly successful one. Specifically it can help inspire greater customer loyalty that allows for growing and retaining market share and margins more easily.

 

That brings us to the final part of Wal-Mart’s long-term plan – adding critical capabilities, both in terms of supplies and logistics, as well as an increased focus on improved employee relations and training. This is another way that Wal-Mart is copying Costco, which has become famous for its high employee compensation and investment in its workforce.

 

The reasoning behind this is simple. Wal-Mart believes that by investing in its employees, including training employees in what it calls “career pathways” at its various Wal-Mart managerial academies (which now number 100 across the U.S.), the company believes it can achieve higher customer satisfaction, increased employee retention, and higher productivity.

 

For example, in order to get ahead of numerous states raising their minimum wages, Wal-Mart has decided to embrace the idea of paying employees greater wages in exchange for promotion to more managerial roles. It plans to annually train around 225,000 employees at its academies in order to lower turnover and better prepare its workforce for a future in which robots will play an increasing role in boosting store productivity.

 

That in turn can help it to further improve its margins and returns on capital which, thanks to its “everyday low price” pledge, have struggled to keep up with its industry peers in recent years.

 

 

Key Risks

While Wal-Mart’s plan to embrace technology, improved stores, and a more well paid and motivated workforce is bearing fruit, there are still several big risks to consider before adding the stock to your portfolio.

 

First and foremost, remember that Wal-Mart is in a very competitive industry, one that is experiencing the greatest disruption in about a century. That means that even if it can successfully survive the rise of e-commerce, by copying elements of Amazon’s and Costco’s business models, that doesn’t necessarily mean that this will translate into strong earnings, cash flow, and dividend growth.

 

For example, in the past few years, Wal-Mart’s investments into future tech and a better work force have resulted in a small but significant erosions in its margins and returns on shareholder capital.

 

 

A big reason for this is that Amazon’s founder and CEO Jeff Bezos has been fanatically focused on maintaining Amazon as a “day one” company. That means he is always striving to improve the customer experience and disrupt other industries before they disrupt him. Specifically, Bezos is famous for trying to maintain Amazon’s pricing lead, having stated in the past that “your margin is my opportunity.”

 

And keep in mind that Amazon is such a highly diversified business, including a massive free cash flow cow in the form of Amazon Web Services (AWS), the world’s largest cloud computing platform, and Amazon Prime, which analysts estimate has 80 million subscribers in the U.S. alone.

 

This means that Wal-Mart’s most important rival has a major competitive advantage. The high margin, recurring revenue streams from AWS and Prime can fund and offset massive investments into new technology, business lines, and distribution centers, as well as ensure Amazon enjoys a long-term pricing advantage through supporting loss leaders and avoiding the high costs required to operate brick-and-mortar super stores.

 

In other words, Amazon can afford to subsidize its rock bottom prices while Wal-Mart can’t. Instead, Wal-Mart will need to rely on its massive scale to squeeze its suppliers and offer products as cheaply as possible in an effort to avoid being undercut by Bezos. It remains to be seen what level of profit, if any, Wal-Mart’s e-commerce business can generate in the future, but it’s key to the company’s long-term relevancy.

 

Meanwhile, even if Wal-Mart can achieve highly successful growth in its online business, such as the 30% annual growth through 2022 that analysts currently expect (according to Morningstar), that would raise its overall online sales to $77 billion compared to $16 billion in 2016. While that’s an impressive amount of growth on an absolute scale, it will be just a drop in the bucket for a behemoth of Wal-Mart’s size (over $485 billion in revenue last fiscal year).

 

Or to put it another way, even if Wal-Mart is able to stave off Amazon’s rise in the e-commerce space, there is no guarantee that it will translate into significantly stronger top or bottom line growth, which could mean that the firm’s dividend growth might remain tepid going forward.

 

And then of course is the risks that Wal-Mart will have to further lower its prices on its biggest product category, groceries, to compete with hard discounters such as Aldi and Lidl. Both are popular ultra-value grocery chains that are planning major U.S. expansions in the coming years.

 

Finally, we can’t forget that there is regulatory uncertainty, specifically the trend of states raising minimum wages to as high as $15 per hour in the coming years. Up until now Wal-Mart has been able to adapt successfully to this threat, embracing it as part of a company-wide focus on a better paid more productive workforce.

 

That being said, there is no guarantee that the company will be able to truly pivot its massive army of workers to achieve the kind of productivity gains that can justify a doubling of wages and rising healthcare costs.

 

Wal-Mart’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Wal-Mart Dividend Safety Score of 96 indicates that it pays one of corporate America’s most secure and dependable dividends. That’s not a surprise given that the company has a streak of 44 years of steadily rising payouts, in all manner of economic and interest rate environments.

 

 

Wal-Mart’s solid dividend security is the result of two main factors. First, management has been very disciplined in growing the dividend at a rate that ensures each year’s dividend is well covered by both earnings and free cash flow (FCF) per share.

 

You can see that the company’s earnings payout ratio has about doubled over the last decade but still remains a reasonable level near 50%. Wal-Mart’s free cash flow payout is even more conservative at 30% last year. That in turn creates a very strong buffer for the dividend in the event that sales, earnings, or cash flow unexpectedly declines in any given year.

 

 

A steep decline in profits is unlikely, however, because most of Wal-Mart’s business is recession-resistant in nature. With over half of its sales tied to groceries, Wal-Mart actually grew its sales and earnings per share by 1% and 8%, respectively, during the financial crisis while holding margins relatively steady. More impressively, WMT’s stock returned 20% in 2008 while the S&P 500 dropped by 37%.

 

The other major protective factor for Wal-Mart’s dividend is the company’s strong balance sheet. Wal-Mart’s debt load isn’t high enough to force management to choose between investing in the future growth of the business and the steadily growing dividend to reward loyal shareholders.

 

At first glance, Wal-Mart’s absolute debt load of almost $46 billion might appear dangerous. However, you need to keep in mind that brick-and-mortar retail is a highly capital intensive industry, and Wal-Mart is generating a massive amount of free cash flow with which to service its debt and obligations.

 

 

When we compare Wal-Mart’s debt metrics against those of its peers, we can see that it actually has a smaller than average leverage ratio and debt to capital ratio. Combined with a very high interest coverage ratio and a strong investment-grade credit rating, Wal-Mart should retain strong access to cheap debt, a helpful advantage in a rising interest rate environment.

 

 

Wal-Mart’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Wal-Mart’s Dividend Growth Score is 46, which is about average for large blue chips that make up the S&P 500. This is both due to the company’s strong long-term payout growth rate, as well as its potential for quicker dividend increases than in the past few years (you can see that dividend growth has averaged just 2.1% annually over the last three years).

 

 

Now it’s important to distinguish potential dividend growth from likely growth. After all, since 2013 Wal-Mart has been giving investors a token 1 penny per quarter annual increase that basically just offsets inflation.

 

Over the long-term the company will probably be able to moderately accelerate that growth if analysts’ expectation for 2% to 3% annual sales growth comes true. When combined with share repurchases of 2% to 3% (in line with its historical norms) and perhaps some margin expansion from productivity improvements, Wal-Mart could achieve a mid-single-digit earnings growth rate if everything goes right.

 

Given the company’s conservative payout ratios, it seems possible that management could reward patient investors with mid-single-digit dividend growth under that scenario rather than the 2% increases recorded in recent years. However, whether or not Wal-Mart actually does this is another question, one that depends on continuing good execution of its growth plan and the rapidly-evolving retail and e-commerce worlds.

 

Valuation

In the past year Wal-Mart shares have slightly underperformed the broader S&P 500, but that doesn’t necessarily mean that shares are a great bargain right now.

 

For example, Wal-Mart’s forward P/E ratio of 18.3 is slightly higher than the S&P 500’s forward P/E ratio of 17.7. It’s also much higher than the company’s historical norm of 15.3.

 

When it comes to dividend yield, Wal-Mart’s 2.6% yield is above the S&P 500’s 1.9% and slightly higher than its 13-year median yield of 2.2%. However, even under an optimistic scenario in which Wal-Mart is able to grow its earnings per share by 5% per year, the stock’s annual total return potential sits close to 8% (2.6% yield plus 5% annual earnings growth).

 

While Wal-Mart is a lower risk stock thanks to the more defensive nature of its business, I prefer to invest in companies that have a clearer path to generating close to a 10% annual returns while becoming a larger, more profitable business over the next five to 10 years.

 

I struggle to believe that Wal-Mart deserves a premium valuation multiple relative to the market given the growth challenges it faces, and its dividend growth profile remains inferior to other higher-yielding, faster-growing blue chips such as Johnson & Johnson (JNJ).

 

Concluding Thoughts on Wal-Mart

Wal-Mart is the kind of defensive, slow-growing giant that one can likely depend on for highly predictable and (slowly) increasing income. That being said, it’s still too early to determine whether or not management’s long-term growth plan will prove successful in competing with more nimble rivals like Amazon in the age of disruptive e-commerce.

 

After all, even Warren Buffett has been selling shares of Wal-Mart in his dividend portfolio. He recently made the following comment about the retail industry, too:

 

“I think retailing is just too tough for me, just generally. We bought a department store in 1966, and I got my head handed to me. I’ve been in various things in retailing. … I bought Tesco over in the UK and got my head handed to me. Retailing is very tough, and I think the online thing is hard to figure out…I have no illusion that 10 years from now will look the same as today, and there will be a few things along the way that surprise us. The world has evolved, and it’s going to keep evolving, but the speed is increasing.”

 

Whether or not Wal-Mart is a reasonable buy at today’s prices depends on your risk tolerance, time horizon, goals, and most importantly, your trust in management’s ability to deliver on its promise of potentially stronger payout growth in the years ahead.

 

While the company’s dividend continues to look safe and Wal-Mart is indeed a defensive stock, I personally remain skeptical of the company’s long-term growth prospects and don’t believe the stock’s current valuation multiple and dividend yield compensate investors for these risks.