Writing May Be on the Walmart

Originally posted at Briefing.com

Walmart held its annual meeting for the investment community on October 14. The mood going into the event was light. The mood coming out of the event was dark—very dark. Why? Because Walmart issued a nasty earnings warning for the next fiscal year that was basically rooted in the two things everyone has been clamoring for to get the US economy growing above potential again: higher wages and increased business investment.

This column rarely, if ever, ventures into individual stock analysis. We aren't going to start here. However, we are going to fixate on Walmart's update considering it contained an important big picture implication.

Intentions Known

Walmart is the world's largest retailer. In fiscal 2015 its revenues totaled $485.7 billion. Its market capitalization is just shy of $190 billion.

Notably, Walmart's market capitalization pales in comparison to the market capitalization of Amazon.com (AMZN), which is about $280 billion even though Amazon.com generates roughly 21% of the revenue Walmart (WMT) generates on an annual basis.

Amazon.com of course is growing its revenue at a much faster rate than Walmart is and is generally viewed as having much stronger growth prospects over the long term than Walmart does.

The law of large numbers comes into play there, but it's more than that. Amazon.com clearly isn't intent on just being a retailer. The fast growth of its web services business indicates as much.

Walmart is a retailer and always will be a retailer. What it is intent on doing is transforming itself into a modern retailer to take on the likes of Amazon.com and other e-commerce competitors while remaining true to its roots.

To that end, its aim is to improve the in-store experience while enhancing the consumer's ability to shop its stores through digital channels (eg. mobile devices, tablets, apps, and PCs).

Walmart declared at its investment community meeting that it will be the first retailer to deliver a "seamless shopping experience at scale." As part of that effort, it is going to be investing heavily in its employees and its technology. Consequently, it expects a hit to short-term earnings—and by short term it doesn't mean the next two quarters. Walmart means the next two years.

An Earnings Hit

Walmart's fiscal year 2016 ends in January. While the company has seen improvement in its US business, it nonetheless expects net sales growth to be relatively flat. In February it thought FY16 net sales growth would be between 1 and 2 percent, yet the impact of currency exchange rate fluctuations was stronger than anticipated. Excluding currency, net sales are expected to increase about 3 percent for fiscal 2016.

Looking further ahead, Walmart expects sales growth over the next three years to range between 3 to 4 percent annually, which will add approximately $45 to $60 billion in sales.

Notwithstanding the expected growth in sales, Walmart expects FY17 earnings per share (EPS) to decline between 6 and 12 percent, adding that FY17 will be its "heaviest investment period." Operating income will be impacted by approximately $1.5 billion as the company carries through with additional wage increases and technology/store investments to develop its seamless customer experience.

[You may also like: Economy and Earnings Keep Producing Bear Necessities]

Walmart quantified that approximately 75% of the EPS reduction is due to wage investment. In fiscal 2016, the "wage investment" will come at a cost of $0.24 per share.

In February 2015 Walmart announced it would be raising its entry wage to at least $9 an hour starting in April, and, that by February of 2016, all current associates would earn at least $10 an hour. The starting wage for some department manager roles would be at least $13 an hour in summer 2015 and at least $15 an hour starting in the early part of 2016.

Employees who feel better about what they earn should presumably feel better about where they work, giving rise to better levels of customer service. Mindful of that, Walmart knew it was important to embrace its transformation by investing first in its people despite knowing it would put a real dent in its short-term earnings.

The company expects this strategy to pay off in more ways than one, yet one important way is through a resumption in EPS growth. It is Walmart's expectation that FY19 EPS will increase by approximately 5 to 10 percent compared to FY18.

From Bad to Worse

Okay, that's enough of the financial nitty-gritty of Walmart's transformation. Let's now look at how the market reacted to what sounds like a perfectly prudent, strategic approach to managing its business for the long term.

In short, Walmart's stock got clobbered.

The day it provided its financial update, WMT shares plunged 12% from their intraday high and closed at $60.03. That made a bad year even worse for shareholders who had seen WMT drop 26% since early January and trade at levels last seen in 2012 prior to the update.

Shares of WMT haven continued to drift lower. Many reports have suggested the harsh reaction the day of the update was due to investors being caught completely off guard by the FY17 warning. That is, they were dismayed that Walmart didn't find a way to communicate its warning before the investment community meeting took place.

It's doubtful in our mind that the reaction would have been any less severe had it been communicated beforehand. After all, an earnings warning is a surprise any time it is provided.

What It All Means

So, what we know about Walmart now is that it is investing more in its people and its technological processes to improve its competitive position. In doing so, it is demonstrating that the status quo won't work, and, if it won't work for the world's largest retailer, it won't work for a host of other companies inside, and outside, the retail industry.

Companies need to be investing in their future and they are not doing so with a great deal of conviction these days. Despite all of the policy largesse provided since late 2008, nonresidential investment as a percentage of GDP is basically the same as it was in the first quarter of 2008.

Regular readers will recognize the chart below from a prior missive where we bemoaned the lack of business investment as a drag on the US economy.

Companies arguably need to be investing more in their employees. They haven't been on the wage side of the equation, which is another reason why the US economy hasn't hit escape velocity.

Companies instead have been holding the line on costs and have been spending heavily on share buybacks, which has done more for their profit margins and EPS growth than it has for the economy.

Herein lies perhaps the most important implication of Walmart's update. Its profit margins will come under pressure because it is going to pay its employees more and because it plans to invest more to ensure its future success.

[Read: US Retail Sales Confirm Sluggishness]

Walmart's earnings results will suffer in the short term because of the increased expenses, and its stock price has certainly suffered on account of that reality.

What might this suggest then for future earnings growth for the S&P 500 when more companies start joining those ranks? It probably means profit margins will contract and that earnings growth won't be as strong as it is now envisioned.

According to S&P Capital IQ, calendar year 2016 EPS growth is projected to be 8.9%. That is down from 11.4% at the start of this year, but would potentially be at risk of further downward adjustment if business investment and wage growth picks up.

That could be problematic for the 2016 market outlook if either, or both, go up at a pace faster than sales and increased efforts to raise wages lead to increased policy tightening by the Federal Reserve.

In that regard, the writing may be on the wall in Walmart's update, and the subsequent sell-off in its stock, that higher levels of business investment and wage growth could be a blessing for the economy and a curse for the stock market.

About the Author

Chief Market Analyst