Tuesday, January 25, 2011


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Over the past several months,  Wal-Mart's (WMT) stock has not enjoyed the same momentum shared by many of its retail peers. Wal-Mart, which closed around $56 per share on January 21, is up 12.3% since the end of August. That performance pales in comparison to the S&P Retail Index's astonishing 27.1% jump during the same period. Sluggish U.S. results have certainly played a role in weighing down Wal-Mart's stock price, as a weakened basic-needs consumer, and increased competition from dollar stores, have led to six consecutive quarters of same-store sales declines and only nominal operating margin expansion. However, we believe Wal-Mart's domestic troubles may be distracting from what could be one of retailing's more significant international growth stories.

Although we anticipate U.S. issues will eventually be resolved through merchandise mix adjustments and new store formats, Wal-Mart's international operations will likely be the company's primary growth engine going forward. This segment represents approximately 25% of Wal-Mart's revenue, and 21% of its operating income, and we expect it to average nearly 9% revenue growth annually, and generate more than one third of overall revenue over the next decade, compared with just above inflationary growth domestically (combining Wal-Mart U.S. and Sam's Club). Additionally, these estimates could prove to be conservative, as Wal-Mart has established footholds in several rapidly developing economies across the globe.

It's no secret that most U.S.-based retailers have started to look overseas to extend growth opportunities, especially when faced with a lack of new retail real estate developments and inconsistent consumer spending patterns. While most retailers' stated international expansion plans have been isolated to developed Western European nations and China, Wal-Mart has already established a presence in several nontraditional growth markets in South America and Asia through small acquisitions or joint venture arrangements. We believe being the first U.S. retailer in many of these markets will prove to be a meaningful competitive advantage during the next decade: By the time most rivals start to enter these markets, Wal-Mart should have an entrenched presence, and a well-developed understanding of local customs and shopping tendencies.

Wal-Mart has had a tendency to acquire local retail chains, and then implement best practices, a trend we expect to continue. Just last week, Wal-Mart completed its acquisition of a 51% stake in South African retailer Massmart Holdings for about ZAR 148 per share (roughly USD $20 per share), valuing the transaction at around ZAR 17 billion (just over USD $2 billion). The transaction was pared down from Wal-Mart's original plan to buy all of Massmart for about $4.25 billion, but we believe a controlling stake is sufficient to give the company a foundation in a rapidly developing South African economy, and open the door for even greater African expansion.

We are confident that Massmart--Africa's largest wholesaler of basic foods, and the third-largest distributor of consumer goods overall, with 290 stores across 13 African countries--can be an immediate contributor to Wal-Mart's international operations. Massmart has increased its top line by about 11% annually the past three years (including ZAR 47.5 billion in fiscal 2010) and delivered EBITDA margins of about 5%. We expect these metrics to gradually improve, as Wal-Mart enhances logistics and distribution capabilities, implements best practices in emerging market store formats, and accelerates growth across the African continent. The acquisition should keep Wal-Mart's international operations on pace to deliver high single-digit revenue growth over the next decade. We also believe the Massmart acquisition could be the first of several acquisitions in other emerging markets, including possible targets in Brazil, Chile, Argentina, China, Japan, Russia, and India.

Wal-Mart in Mexico and Central America
Mexico was Wal-Mart's first international foray through a joint venture with Cifra to open a Sam's Club in Mexico City. Although the company stumbled in the beginning as it struggled to understand the consumer dynamics in the market, Mexico is now one of Wal-Mart’s greatest success stories. The company wisely acquired a majority stake in Cifra in 1997, the largest player in Mexico at the time, which was renamed Wal-Mart de Mexico in 2000. Cifra's knowledge of the local market, combined with Wal-Mart’s own best practices and immense resources, became the blueprint for the company's international acquisition program. Today, Wal-Mart is the leading retailer in Mexico with almost 1,700 stores under the Wal-Mart, Bodega, Suburbia, and Superama banners.
Given its dominant presence in the country, we don't expect acquisitions to play much of a role in the company's growth plans going forward, and instead believe that it's more likely that the company will look to organically expand its Wal-Mart Supercenter, Bodega discount, and Suburbia apparel/footwear retail formats instead. In fact, with Wal-Mart's Mexican and Central American operations (Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua) operating under one structure since December 2009, and few suitable acquisition targets, we believe Wal-Mart will continue to focus on organic growth in this region.

Wal-Mart in Brazil
Wal-Mart has admitted that Brazil, along with China, is one of its greatest sources of growth. Brazil is the fastest growing economy in Latin America, and millions have already leaped into the ranks of the middle class. Consensus estimates now project that annual spending on food in Brazil will rise 50% over the next five years. However, Brazil has also generated a great deal of competition among retailers hoping to capture this demand. With 461 retail units, Wal-Mart ranks third in sales, behind Carrefour and Companhia Brasileira de Distribuicao (CBD), a domestic operator of 1,000 stores (including Grupo Pao de Acucar) that is 34% owned by Casino Guichard-Perrachon. Together, these three companies are responsible for about 38% of Brazil's total retail sales.

In 2010, Wal-Mart invested $1 billion for new stores and infrastructure upgrades in Brazil. With its unmatched resources, Wal-Mart is outspending Carrefour while committing less than 10% of its overall budget, while Carrefour is spending approximately one-fifth of its budget on its Latin American operations. Meanwhile, even though CBD is currently the leading retailer with respect to sales volumes, its overall margins of 4% lag its competitors, and it has access to vastly fewer resources. In our view, this raises questions over how long CBD will be able to maintain its top position. Although Wal-Mart has grown organically in Brazil, the acquisition of Bompreco (118 stores) and Sonae (140 stores) helped to significantly bolster the company's regional presence. Currently, all three players are trying to protect their market share, so the search for acquisition targets is competitive, and could potentially require a large multiple for any large operator, in our view.

Despite the increasingly competitive landscape, a handful of intriguing joint venture arrangements are still possible in Brazil. We'll rule out a relationship with Lojas Americanas after its ill-fated Wal-Mart Brasil partnership from 1994 to 1997, but a retailer like Casas Bahia Comercial (a 500-location mass merchant of furniture, appliances, and other household goods) or one of Brazil's larger online retailers strike us as potential ways to capture incremental share in this rapidly developing marketplace.

Wal-Mart in Chile and Argentina
Wal-Mart generated a great deal of buzz in 2009 when it purchased Distribucion y Servicios (D&S), Chile’s third largest retailer, for $1.5 billion dollars, essentially making Wal-Mart South America's largest retailer. Unlike many of the other South American markets, Wal-Mart is the only major international player in Chile, and presently controls more than 30% of total hypermarket, superstore, and warehouse store sales, according to the USDA Foreign Agricultural Service. Nevertheless, local competitor Cencosud is no pushover. In addition to extensive holdings in Brazil and Argentina, Cencosud controls approximately 29% of the market. However, whereas it appears that Cencosud is focusing on its assets outside of Chile (as shown by its $813 million dollar acquisition of Brazilian operator Bretas and ongoing more than $200 million spent on new supermarkets in Peru), Wal-Mart seems content on growing its operations in Chile for now, and will invest $300 million into this market in 2011.
Unlike Chile, Argentina has many international retailers, with Carrefour,  Casino Guichard-Perrachon, and Wal-Mart all competing for share. With only 7.9% of the market, Wal-Mart lags behind industry leader Carrefour (24.6%), Cencosud (18.1%), and local retailer Coto (12.6%). In order to catch up, we believe that Wal-Mart will have to grow via acquisitions in Argentina. Retailers La Anonima ($900 million in annual sales, 116 outlets, and a 7.5% market share) and Toledo ($184 million in annual sales, 34 outlets, and a 1.5% market share) are the most attractive targets in our view, as they would allow Wal-Mart to gain scale and make up group relative to its competitors. Although it previously dismissed rumors that Wal-Mart would acquire the company, we also believe that Coto (117 outlets, 12.6% market share) could be an attractive opportunity that would allow Wal-Mart to significantly close the gap between itself and Carrefour. In addition, if Casino Guichard-Perrachon ($440 million in annual sales, 65 outlets, and 3.7% market share) is unable to successfully expand in Argentina, Wal-Mart could potentially take control of some of its assets in the region.

Wal-Mart in China
Wal-Mart is very bullish on its prospects in China because, in addition to the vast potential of its economy, the Chinese rural landscape is very similar to that of the United States, where Wal-Mart has achieved the most success. Currently, the majority of Wal-Mart's stores are in first- and second-tier cities, where both population density and disposable income are relatively high. However, Wal-Mart has also started using smaller discount hypermarket models to expand outside of these zones. As incomes increase and the middle class ascends, Wal-Mart will most likely target these underdeveloped areas as a key source of growth. As a foreign operator, Wal-Mart already enjoys a reputation for high quality products in China. Frugality reigns in China, and Chinese customers are very value-oriented. We think there is great potential if Wal-Mart can successfully implement its “Everyday Low Price” strategy in China.

Many foreign retailers prefer to acquire local businesses that are familiar with Chinese bureaucracy, and institute best practices. However, it is difficult for foreign operators to acquire very large Chinese retailers, since homegrown businesses are typically favored by the government, and most retailers have grown quickly, so an acquisition will require a high multiple. This is why it was such a coup for Wal-Mart when it successfully outbid Carrefour in 2007 to buy a 35% stake in Trust-Mart, a Taiwanese operator with around 100 stores in China, for approximately $1 billion. Including its Trust-Mart operation, Wal-Mart has 311 retail units, and opened 47 stores in 2010 compared to only 30 stores for Carrefour. In addition to traditional retail, Wal-Mart recently invested in 360Buy, one of the leading e-commerce players in China.

Although we believe that Wal-Mart is constantly on the lookout for acquisition targets, we believe that the company is now in a position to grow, primarily organically, in China. Since many of the first-tier cities are becoming saturated, Wal-Mart will most likely focus on expanding into second- and third-tier cities through organic growth and small acquisitions. Not too long ago, Carrefour was plagued with concerns about its European business, and eventually sold a few of its stores to Tesco in order to focus on its home operations. Although Carrefour has since reinvigorated its Chinese operations, it’s possible that Wal-Mart could acquire troubled operations from other foreign operators struggling to build scale in China.

Wal-Mart in Japan
Due to the Large Scale Retail Store law, the Japanese retail market is fragmented, and much of it is still serviced by independent operators. Wal-Mart saw the potential to consolidate part of a huge market, so it acquired a minority stake in Seiyu in 2002, and increased the size of its stake until Seiyu became a wholly owned subsidiary in 2008. Japan is an extremely important market, because an established presence there would let Wal-Mart gain synergies from its existing U.S.-China shipping routes, so that otherwise empty freights could now carry goods to Japan on the return trip from China. In addition, since Japan relies on imports for much of its citizens' basic needs, Wal-Mart’s extensive worldwide distribution system will allow it to cut costs and get a huge leg up over its opponents. However, Wal-Mart failed to adapt to the Japanese market and Seiyu faced seven straight years of losses.

Many industry watchers actively speculated that the retail giant would follow Carrefour, which exited Japan after five years of similar, disappointing results. These critics believed that a Western discount retailer would not be able to succeed in Japan, since Japanese consumers typically live in small, urban apartments, and are more likely to associate price with quality. However, the global economic crisis has lifted discount retailers across the board, and Seiyu has become productive enough to be profitable on a net basis. Believing that this shift towards value will be permanent, Wal-Mart has stated that it wants to expand stores and increase scale. It is critical that Wal-Mart gain scale.

Since the retail space is already so crowded in Japan, organic growth is not a viable option. Scott Price, the president and chief executive officer of Wal-Mart Asia, stated that Wal-Mart will aim “to take over stores where the current operator is not successful and wants out, or acquisitions that fit our model and are not troubled.” Given the fragmented nature of the Japanese retail market, there are a number of smaller chains under $8 billion in annual revenue that could be viable tuck-in acquisition targets, including certain assets of the Beisia Group (1,780 locations across Japan, including 150 superstores), Don Quijote (160 locations in Japan, as well as four locations in Hawaii), and Izumi Company (80 store locations).

Wal-Mart in Russia
Wal-Mart closed its Moscow representative office in December 2010 after failing to find a suitable acquisition partner, but we believe a few chains could still be takeover targets over the next few years. In the words of Doug McMillion, president and CEO of Wal-Mart International, "Since [Wal-Mart has] decided to enter the market through acquisition, not greenfield development, and since there is no clear acquisition partner in the near term, there is not a business reason to continue our Moscow representative office. We will continue to pursue market entry opportunities." At various points during the last year, the company was reportedly interested in buying discount retailer Kopeika (a 600-store chain generating roughly $1.7 billion in annual revenue) and cash-and-carry warehouse operator Lenta (representing $1.9 billion in annual revenue through almost 40 locations). However, Kopeika was taken over by X5 Retail, Russia's largest retailer, in December. Lenta has apparently fallen off Wal-Mart's radar after a dispute between rival investor groups over its rightful CEO.

Russia may be one of the more difficult markets for Wal-Mart to enter through an acquisition. The country's largest retail chains--X5 ($9 billion in annual sales and about 1,400 stores) and OJSC Magnit ($5 billion and more than 3,500 stores)--already control many of the most attractive real estate locations for large-format stores, and could be difficult to acquire given large ownership stakes by Alfa Group Consortium and Magnit-founder Sergey Galitsky, respectively. Nevertheless, we believe a few viable Russian takeover candidates still exist for Wal-Mart, including Dixy Group (600 stores generating nearly $2 billion in annual revenue) and Victoria Group (over 200 stores, $1.3 billion in revenue). Seventh Continent (150 locations, $1.5 billion in revenue) and Lenta could also be prospective candidates, but weak operating results and stewardship issues could present potential roadblocks for a joint venture or acquisition.

Wal-Mart in India
Wal-Mart, and other giant multibrand retailers, have been blocked from entering the retail market in India by its foreign direct investment ("FDI") policy. This policy specifically denies general merchandise retailers permission to enter the Indian market. The main reason behind the trade policy is opposition from small shopkeepers, who still account for the majority of retail sales in India. Currently, fewer than 10% of Indian consumers shop in Western-style supermarkets. The FDI restricts single-brand retail to 51% ownership, while direct general merchandise retail is barred completely. However, under the “cash-and-carry” format foreign investors can gain 100% ownership because the cash-and-carry shop engages in back-end wholesale, causing no direct threat to small retailers in India. Wal-Mart was one of the first Western retailers to take advantage of the cash-and-carry format by signing a deal with Bharti Enterprises in November 2006 to “jointly explore business opportunities” in India. The 50/50 joint venture between Wal-Mart and Bharti has expanded and now the giants are looking for opportunities to expand into the south and west, including Bengal.

Despite heavy political and social resistance to direct retail investment in India, Wal-Mart’s CEO Michael Duke says he is “optimistic” that foreign investment will be allowed in India’s retail market. The trade ministry has extended invitations for opinions on changing the current restrictions, following a government discussion paper released in July 2010 that pointed to benefits of foreign retail investment, including lowering prices and helping farmers. Earlier this year, Wal-Mart started working with farmers in India with “direct farm programs” in Punjab and Delhi, providing basic agricultural techniques and more efficient transportation. In his New Delhi speech, Duke announced that Wal-Mart’s goal is to “buy directly from 35,000 small and medium farmers in India by the end of 2015”. Duke said allowing foreign investment in retail can curb inflation, increase efficiency in the supply chain, and create as many as 3 million jobs in India; “the opening of dialogue the ministry has initiated is very productive, and I view that as progress” said Duke. However, Duke admits that an opening of the Indian retail market will be gradual and “calibrated.”

International Operations Could Provide Upside to Our Valuation Assumptions
We find Wal-Mart's current share price moderately attractive, at less than 13 times our forward fiscal-year earnings per share forecast, an enterprise value/EBITDA multiple of 6.8 times, and a free cash flow yield around 5%. International operations drive much of the our present discounted cash-flow model assumptions, including revenue growth of about 10% annually over the next five years (driven by 8% square footage growth and 2% revenue growth per square foot) and 5.3% operating margins. However, if Wal-Mart were to maintain annual international revenue growth in the midteen range (the average over the past five years) through a combination of acquisitions, joint-venture arrangements, and organic growth in the aforementioned emerging markets, there could be considerable upside to our fair value estimate.

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