A Tale of Two Retailers – the importance of cost advantage

With all due respect to Charles Dickens, the title couldn’t be helped when we contemplated the fates of both Wal-Mart (WMT) and Best-Buy (BBY) this weekend, and the longer-term prospects for both.

For the first time since January, we bought some Best Buy (BBY) late Friday, more for a shorter-term trade than a longer-term belief in a turnaround, but we believe BBY has bottomed for now, if only to catch the oversold month-end rally into the end of May.

To study BBY and WMT is to examine the power of structural cost in retail, and how Best Buy’s structual cost problem is (or could be) a death knell, while Wal-Mart’s structural cost distribution advantage is an enormous competitive moat.

Both companies sport roughly a 25% gross margin, but while BBY’s operating margin is 3.9% – 4%, WMT’s operating margin is 5.50% – 6% over time,  or almost 150 – 200 bp’s better. While WMT’s legendary control over suppliers shows up in cost of goods sold, and the gross margin, very few give the company credit for its operational expertise and productivity emphasis.

Harvard Business School’s Professor Michael Porter’s  Five Forces of competitive strategy (Rivalry, Threat of Substitutes, Buyer Power, Supplier Power, Threat of New Entrants) is a perfect framework to analyze both retailers, but to keep the analysis short and sweet and digestable for readers, the fact that Best Buy is now competing with online retail (not to mention warehouse clubs like COST and Sam’s) with lower fixed-cost advantages, particularly with cut-throat pricing in the TV market, the stock has clearly been punished. The fact that WMT has this kind of control over margins, as well as other levers to pull is enormous as an operational advantage, while BBY struggles with rapidly changing technologies and constant price pressures. However, for BBY not all is lost. Here is a quick summary of the positives around BBY right now (we clearly know all the negatives):

1.) Valuation – at $19 per share, BBY is trading at 0.14(x) 4quarter trailing sales to market cap. The only stock i’ve ever seen that cheap is Sears Holdings, not to mention BBY’s 3(x) enterprise value to cash-flow and the 5(x) earnings.

2.) Analyst estimates have remained fairly stable for fiscal 2013, 2014 and 2015. For this fiscal year, even with the confusion around the extra week and the change in the fiscal year period (from Feb to Jan each year), BBY’s 2013 eps estimate trend has been $3.75, $3.62 and $3.61 for the last 3 quarters consecutively, leaving BBY trading at 5(x)  this year’s estimate;

3.) Some of the TV manufacturers instituted a “uniform pricing policy” (UPP) which would reduce price-cutting in select distribution channels for high end TV’s, as vendors try to get more uniform pricing among online, warehouse clubs and traditonal retail. Obviously this would help BBY in this product line, since the dramatic price-cutting at the low end might abate to some extent;

4.) Amazon recently agreed to start paying sales tax in Texas, potentially opening the door to other states looking to improve fiscal conditions. The lack of sales tax is a huge competitive advantage for AMZN against traditional brick-and-mortar retail – is this advantage in the early stages of disappearing ? (we are long a little bit of Amazon by the way);

5.) BBY’s dividend is between $220 ml – $230 ml per year, while 4-quarter trailing free-cash-flow as of the May quarter is $1.6 bl. I do NOT think BBY’s dividend is in jeaopardy since even with this latest pressure on the business BBY has remained free-cash-flow positive. BBY’s current dividend yield is 3.50%.

6.) Interim CEO Mike Mikan was supposedly well received on the May c0onference call for his upfront comments about what is needed to turn around the business. Mikan also bought a slug of BBY stock near $17 – $18 per share in the last two weeks. As the old saying goes, “there are many reasons for insiders to sell, there is only one reason to buy” (i.e. the stock is headed higher).

The negatives around BBY are well known. The stock trades like RIMM down here, but with better prospects in my opinion. However for right now we are long BBY for just a trade.

Several technicians have noted the recent mini breakout in Walmart (WMT), however on our chart the stock needs to trade over $70 (the January 2000 high) on heavy volume before the stock truly breaks out. What is fascinating about Walmart, and what is emblematic about the market the last 12 years, is that in January, 2000, Walmart (trading at $70 per share) generated $166 bl in annual revenues and $1.28 per share in fiscal 2000 (ended January, 2000). Today Walmart generates $450 bl in annual revenues and $4.50 in earnings per share, so as the stock has gone nowhere for 12 years, while revenue and earnings have TRIPLED since that time, typifying the “p/e compression” we wrote about on this blog last week.

Walmart’s recent price action is a function of the turnaround in US comp’s which rose to 2.6% last quarter, the best quarterly US comp since Jan ’09 or the height of the US recession when WMT grabbed share from traditional higher-cost retail. In addition, WMT’s revenue beat in the April quarter of $113 bl, (versus the $110 bl expected) was the largest upside revenue surprise since April of 2008.

WMT is driving price (EDLP or every day low price), and sacrficing gross margin for traffic and market share, and the strategy is starting to pay off, to stave off the Dollar Stores (DLTR) and other low-end competitors.

Guess which WMT product category was the only line to not comp positive in the April quarter ? Electronics. (Cant be good for BBY, when WMT is slowly cutting off your air supply).

However I think there is something else here at work too. Wal-Mart has long been locked out of the Chicago market (all politics, and is a perfect example of why Chicago doesnt work economically) since the Chicago City Council has refused to allow WMT to put up big box stores in the city limits, (unions, benefits, etc.) However, WMT being the constant innovator that they are, is now opening WalMart Express’s and WalMartNeighborhood Markets. I’ve seen 2 Walmart Express’s on the north side of Chicago, and a Wal-MartNeighborhood Market downtown, which are much smaller stores with limited product lines. Wal-Mart’s revenues are now 50% grocery, and with the trend towards smaller square footage by all retailers (like Whole Foods, Best Buy, ) Wal-Mart has gained entry into a previously closed market and is grabbing foot traffic. While WMT’s Neighborhood Market is more food and less general merchandise and the WMT Express is more balanced, both concepts are newer for WMT and allow the company to gain entrance to heavily-urban and union-dominated cities. (Right now these stores are too small in number to move that WMT revenue needle, but the new market entry isnt lost on observers.)

Most pundits gave up on WMT years ago, saying “the law of large numbers” will crush it, and the gigantic stores are outdated,  however,WMT went through a similar period of stagnant comp’s from the late 1980’s to about 1995, and then the stock exploded (sorry for the hyperbole) from 1996 to 2000, trading from a split-adjusted $10 to $70. Obviously, the enthusiasm around large-cap growth stocks in the late 1990’s helped inflate WMT’s valuation, but today, both large-cap growth sentiment and sentiment around WMT in particular, seem to have compressed the stock.

We’ve been long WMT as a long-term core consumer staples position with an initial position at $50, and then more at $55 – $57, but the real technical test comes at $70.

WMT’s valuation isnt as attractive as Best Buy, but you dont have the problems. Trading at 0.45(x) 4-quarter trailing sales to market cap, and 12(x) earnings for EXPECTED mid-single-digit growth the next few years, we’d be a better buyer of WMT closer to $60 or under, but the technicals are the key to watch here. Housing is important to WMT here too, given their demographic. To move US comp’s significantly higher i think we need housing to recover, and while that seems to be happening, we need to see a widespread recovery in national housing and while housing is getting less worse, it isnt yet truly getting better.

Wal-Mart and Best Buy are (unfortunately) on two different tracks. Can BBY turn it around, shrink square footage, drive more online sales, narrow the Amazon price differential and reinvent the core store concept ? Can Wal-Mart continue to drive US comp improvement, be a retail juggernaut, hold off Dollar Tree and Dollar Stores, and other low end market entrants, and move the needle on $450 bl (or roughly 10% of all retail sales) in revenues ?

The competitive threat to Wal-Mart is miniscule relative to what Best Buy is facing, and you have two vastly different prospects facing the two companies.

Long WMT (core position, look to add under $60, would love it near $55), long BBY (probably for a trade, maybe longer), long Whole Foods, long COST, long AMZN (would buy more near $200)

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