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WMT: Our Tone is Changing

Yeah, WMT is likely to beat tomorrow, but revenue visibility is likely to come up short. Mgmt is failing to execute on a plan to offset its self-deflationary model, and time is running out. If WMT can’t perform in a cyclical bounce, how can they do so in a double dip? Tack on overlap with Obama’s Housing Finance Conference tomorrow, and the headlines don’t look good.

In February (2/11) we wrote a post entitled “The Rut of Consistency” which outlined the reasons why Wal-Mart shares were likely to stay in a trading range.  In this post, we explained that even with a flurry of organizational changes and strategic initiatives underway for 2010, the ultimate reward to both earnings and share price was simply driven by the potential for increased customer traffic and pricing power resulting from merchandising improvements.  We believe both of these areas are unlikely to show any signs of improvement with tomorrow’s 2Q report. 

We went on to write:

As a result, in the near-term there is little to suggest that the company’s fundamentals and share price are anything more than still stuck in a narrow range.  To meaningfully break this cycle of monotony, we would have to see a few key things: 1) merchandising efforts actually work and drive a mix shift back towards discretionary goods, which in turn drives average ticket and margins higher, 2) a meaningful pick up in contribution from international at higher EBIT margins (unlikely as the non-U.S units collectively remain in growth mode) and 3) an acceleration in traffic (share) growth as a result of all of the above-mentioned efforts combined.  In theory, achieving this short list is what management needs to do to get out of the rut of consistency.  In reality, the hope of inflation as a savior and reliance on merchandising changes to drive margins higher are likely to be disappointing to those looking at 2010 as a breakout year for the largest company on the planet.

That brings us to today, exactly sixth months later and our thesis is very much unchanged.  Tomorrow Wal-Mart will report earnings that on the surface will be very close to the Street’s expectations.  Maybe a penny or two of upside, but all eyes will again be focused on the top line.  We have no special insight or “channel check” that tells us where exactly domestic comps will shake out, but our best guess tells us it’s slightly negative again.  After all, sales momentum slowed across the board for all types of retailers in Q2 and we don’t expect anything different from WMT.

Revenue gains remain a challenge based both on the law of large numbers that keep traffic under pressure and the fact that Wal-Mart’s pricing prowess continues to self-deflate the sales line.  We also believe recent management changes in the U.S offer the clearest signal that sales remain under pressure.  If it ain’t broke, why fix it? The bottom line here is that Wal-Mart is struggling to give the consumer a reason to shop its stores beyond price alone.  A scenario we see no signs of abating anytime soon and one which will again be made clear with tomorrow’s report.  So long as the consumer remains challenged to find higher wages and overall employment, Wal-Mart is unlikely to convince Americans that that they should be buying more “want” and less “need”.  As a result, tomorrow’s scripted call will likely be more about “opportunities” in merchandising,  maintaining price leadership, and importantly how the Wal-Mart customer remains challenged.  All of these items will come to light on a day that shares headlines with the Obama Administration Conference on the Future of Housing Finance and will likely rekindle a day of focus on the weak consumer. 

If anything has changed, it may be our bias that the shares will stay in a range.  We believe that while expectations are low enough and any rational investor knows it takes time to move a ship as big as Wal-Mart, patience is running out.  The efforts to improve the company’s apparel program have fallen short (again), as has a Sam’s Club revitalization.  There is little to grasp onto from the “story” side of things here, and the results themselves are just not good enough to keep investors interested indefinitely.  We believe the rut of consistency may be nearing an end and the “safety” factor that has kept so many investors waiting patiently for margin expansion driven by the topline is being pushed out into the future once again.  From a risk perspective, the size and complexity of the organization alone gives us comfort that we’ll have plenty of time to change our minds if some day the latest team of merchants finally gives the consumer a reason to spend more within Wal-Mart’s price-driven box.  For now, we’re looking elsewhere for investment opportunities both long and short where we can identify more meaningful catalysts.

- Eric Levine

WMT: Our Tone is Changing - WMT SIGMA