Tuesday, July 12, 2011

Selling Wal-Mart Back to the Walton Family: Part 2

A follow up to this post and a further look at how Wal-Mart (WMT) compares to Amazon.com (AMZN).

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

Wal-Mart currently sells at roughly 12x current-year earnings. These days, that's not actually all that unusual as their many large cap quality franchises selling at or near similar recent valuations.

Last year, Wal-Mart earned $ 16.4 billion.

Amazon earned $ 1.15 billion.

More than 14x more in current earnings power.

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

That comparison, in itself, of course doesn't reveal a whole lot. Wal-Mart's business could, as some seem to believe, stagnate while Amazon's business economics may eventually improve after they get past the heavy investments in the business they are making.

Somewhat surprisingly, the gap in absolute earnings between Wal-Mart and Amazon has actually increased in recent years. For the two years ended fiscal year 2010, Wal-Mart added ~$ 3.0 billion to its annualized earnings run rate by while Amazon added $ 407 million. Though, of course, Amazon grew earnings faster in percentage terms off of its rather smallish earnings base.

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

We know that Wal-Mart is earning 14x more each year but some say the superior long-term growth prospects of Amazon justifies that stock's premium valuation. 

Well, which of the two options below seems the better deal?

Option 1: $ 100 billion that buys $ 407 million in cumulative 2 yr earnings growth, a current $ 1.15 billion earnings run rate and a seemingly, at least today, great long-term growth story.

or

Option 2: $ 185 billion buys $ 3.0 billion in cumulative 2 yr earnings growth, a $ 16.4 billion earnings run rate and, I guess, a not so great story. (As an investor, I happen to like boring stories like Wal-Mart.)

Since I can't spend percentages or stories I'll take option 2. For less than 2x the price I get vastly superior economics and not much good has to happen to make very healthy long-term returns. In contrast, many good things have to happen to Amazon just to support its valuation.

Wal-Mart is cheaper compared to current earnings and the growth in its dollar, if not percentage, earnings. The above, in part, explains why a high earnings multiple paid for impressive percentage growth frequently does not work out in the long run for an investor. There are exceptions, of course, but odds are the investor is more exposed to the possibility permanent capital loss, or, at least subpar performance at higher than necessary risk.

I realize others, for a variety of reasons, will no doubt still prefer Option 1. If Amazon somehow maintains that percentage growth rate even as it becomes a much larger business then eventually the valuation would make sense. That's a tough sell (at least for my money) on a risk-adjusted basis.

Wal-Mart doesn't have to grow much, if at all, to make investors a nice return. In fact, at current prices nothing spectacular has to happen for investors to do well. In recent years, the company has been consistently buying back its stock below intrinsic value. As I noted in the previous post, Michael Santoli's article in Barron's points out investors are effectively selling Wal-Mart back to the Walton family.*

On the other hand, at current prices Amazon needs to be spectacular as a business just to produce a decent return for investors. You can be sure that if Amazon doesn't continue to grow rapidly and for a very long time the returns will be less than satisfactory.

It's worth noting that very overvalued stocks tend to get even more overvalued so I have no trouble believing Amazon's share price will go even higher from here.  For those that want to trade price action I'm sure it could work out just fine.

Who knows, but as an informed speculative bet, it might just work.

For long-term investors it's different story. Amazon has what looks like a very good business. Someday, the company will probably even justify its valuation (and much more). 

Yet, an investor doesn't (or, at least, shouldn't) put money at risk just so something may justify its valuation (or even 2-3x its valuation) someday.

It is also quite possible that Amazon will end up being worth more than Wal-Mart someday. Even in that optimistic scenario, when fully considering the time it will likely take to become intrinsically worth that much, the shares, at least near the current valuation, still aren't likely to produce satisfactory risk-adjusted returns.

The question for an investor always comes down to a judgment along the following lines:

At the price paid, how does the long run likely returns versus risks compare to other investing alternatives. 

On that score I don't think Amazon works.

I think an investor can quite easily get similar or more attractive long-term returns with more certainty and less downside elsewhere.

Adam

Long position in Wal-Mart

* Shares outstanding has gone from 4.48 billion to 3.51 billion for Wal-Mart (~ 21% reduction) and from 364 million to 459 million for Amazon (~ 26% increase) over ten years. Those buybacks below intrinsic value enhance long-term returns in a not insignificant way over time. They also serve to limit the downside. This assumes that the company is financially strong, has no other strategic need for corporate cash, and the necessary investments are being made that maintain, or ideally enhance, the size and strength of its economic moat.

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