Tuesday, July 12, 2011

Selling Wal-Mart Back to the Walton Family: Part 1

Berkshire Hathaway (BRKA) has a large position in Wal-Mart (WMT). This Barron's article makes the following point about the stock:

...Wall Street is selling the company back to the Walton family. As Wal-Mart has bought back shares at a brisk $15 billion annual clip, the Waltons' ownership is back above 48% and growing every day. Grant's Interest Rate Observer, always keen for contrarian value plays, notes somewhat facetiously that at the current buyback rate, in 15 years there will be one share outstanding.

Taking full advantage of an increasingly inexpensive stock (i.e. earnings grew while stock went nowhere) in recent years, Wal-Mart's (WMT) share count has been reduced by more than 20% via buybacks over the past decade.

Wal-Mart is, in many ways, a long duration bond with a growing coupon in the form of its persistent earnings stream. The buybacks make a ton of sense for a company selling well below its intrinsic value.

It seems to get little attention but, in contrast, Amazon (AMZN) has actually had its shares outstanding grow by more than 25% over the past decade.

A more than meaningful increase.

When a stock is cheap, buying back the shares makes a lot of sense if a company is: financially strong, has a secure economic moat (ideally one that is being expanded/strengthened over time), and no other strategic need for corporate cash.
(Cheap being when shares sell below a conservative estimate of intrinsic business value.)

When shares are expensive, the buybacks should at least be halted. I say at least because, in some circumstances, if the stock sells far enough above intrinsic value it makes sense to sell some shares. Most executives however, for obvious reasons, dislike signaling that the stock is expensive so that doesn't often happen.

What's the next best thing? Avoid buying back the stock and allow the exercise of options to balloon the share count.

Many additional Amazon shares outstanding have been added through the exercise of employee stock options. The ongoing exercise of stock options, if not offset by buybacks, increases shares outstanding.* The cumulative effect, sometimes rather quietly over time, can end up being significant. There's been some buybacks over the years at Amazon but not nearly enough to provide an offset to the share count growth (besides the shares have frequently been far from cheap).

The growth in share count is a bit of a slow burn with the larger impact on shareholders only made evident over many years**.

It's worth noting that some were arguing with a straight face that options are not real expenses not too long ago. Here's the take of Warren Buffett and Charlie Munger on the debate over expensing options. Buffett starts by telling the crowd that the state of Indiana actually tried to change the value of pi in the 19th-century. Well, the bill did pass the Indiana house but, fortunately, the Indiana senate stopped it.

From the 2004 Berkshire Hathaway Annual Meeting:

CNN Money Article

"It seems there was a fellow who discovered some new relationship between circumference and diameter that would help students learn a better kind of geometry, so he wrote a law to change the value of pi from 3.14159 etc. to 3.20. It passed the Indiana house -- until the Indiana senate finally thought better of it."

After the audience stopped laughing, Buffett came to his point about options, "The U.S. Senate concluded that the world was flat, because their contributors paid them enough to say the world was flat."

Then Munger weighed in: "It's worse than that. Those people who wanted to round pi to 3.2 were stupid. These people [the opponents of expensing options] are worse than stupid. They know it's wrong and want to do it anyway."

Back to Wal-Mart. These days, Wal-Mart sells at roughly 12x current-year earnings. The Barron's article also points out Wal-Mart has plenty of growth outside the U.S. but seems to get little credit for it.

Consider that Wal-Mart had $ 16.39 billion in earnings compared to Amazon's rather smallish $ 1.15 billion last year.

So Wal-Mart earns every 3.5 weeks or so what Amazon earns in a year.

Yet, Amazon has anything but a smallish market value. Its market value is now close to $ 100 billion compared to Wal-Mart's $ 185 billion.

I'll follow up on this in another post.

Adam

Long position in Wal-Mart

Selling Wal-Mart Back to the Walton Family - Part II

* When options are exercised, it affects the corporate cash holdings and shares outstanding. The holder of the option pays the strike price to the company upon the exercise of stock options. As a result, the corporate cash increases and new shares are issued. So some of the dollars from the transaction (the strike price x shares exercised) ends up in corporate coffers. In the end, an exercise of employee stock options results in an increase to cash on the balance sheet, an increase to shares outstanding, and the employee gets compensated by the amount above the strike price. Check out Box 2, on page 6 of this paper for a good explanation. In addition, employee stock options provide meaningful tax benefits to the company. This article also provides a simple explanation of how the exercise of employee stock options impacts corporate cash holdings an the tax benefits among other things. 
** Shares outstanding has gone from 4.48 billion to 3.51 billion for Wal-Mart and from 364 million to 459 million for Amazon over ten years.
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