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Market Update

Wal-Mart Stock Worth Selling

The retail giant's shares are moving into selling territory given the firm's cautious outlook and the likelihood of a pullback in consumer spending.

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 Wal-Mart Stores (WMT) reported second-quarter earnings per share slightly ahead but operating profits a bit below consensus estimates. That, along with a more tempered outlook relative to Wall Street expectations and some profit taking, has shares trading down roughly 3%. Easing food inflation should continue to help keep earnings before interest and taxes margins more or less flat for the next two quarters. However, we still expect operating margins to again start declining thereafter, particularly when the company begins to cycle positive rather than negative comparable-store sales. Moreover, although not as severe as in 2008, we expect a pullback in consumer spending and re-emerging food inflation in 2013, so we advise investors to sell the stock at these levels. Shares are trading well above our fair value estimate, which remains unchanged.  

Helped by $1.8 billion in share repurchases, the company reported EPS of $1.18, ahead of the $1.17 mean estimate. But same-store sales in the U.S. of 2.2% and consolidated EBIT margins of 5.86% came in, albeit slightly, below consensus. Comps at domestic stores were positive for the fourth straight quarter, but that was against another negative year-ago comparison. Wal-Mart starts to cycle positive comps next quarter. Average ticket continues to be the main comps driver, but customer traffic trends came in slightly positive again. We believe it's difficult for any retailer to sustain comps trends mainly through increasing ticket until wages begins to meaningfully outpace rising food and fuel costs. On a two-year rate basis, domestic comparable-store sales slowed 20 basis points to 1.3%, and continue to significantly lag the dollar stores. International revenues on a constant currency basis decelerated to 4.7%; management cited slowing global consumer demand.  

Price investments, which we continue view as a positive to defend and drive market share, continue to drag gross margin. This quarter, despite the benefit of easing food inflation, consolidated gross margin came in at 25.1%, an 18-basis-point decline from the year-ago period. This is now the 10th consecutive quarter of gross margin contraction. We expect less gross margin contraction over the next two quarters as food input costs slow. But in 2013, because of the severe drought, we expect margin pressure from food inflation to re-emerge. After five straight quarters of declines, Wal-Mart was able to lower costs and leverage expenses enough to keep operating margins essentially flat this quarter. The company can deliver expense leverage off of even negative comps, but it seems a 2% or higher comp is needed to offset price investments to keep EBIT margins flat. We expect comps to decelerate from current levels in the second half of the year as the company begins to face positive, rather than negative comps.     

In our view, management was smart to provide a more cautious tone. Wal-Mart cited that economic pressure continues the "paycheck to paycheck cycle" in the United States and abroad. Wal-Mart did update and tighten its full-year EPS forecast to a range of $4.83-$4.93, compared with its $4.72-$4.92 prior outlook. For the upcoming fiscal third quarter the company is forecasting to a $1.04-$1.09 EPS range. The mean consensus estimate is at the low end of the range for the third quarter but at the high end for the full year. We believe the EPS outlook for the quarter and the full year are easily achievable, even if sales and margin fall below plan through share repurchases. However, next year our financial forecasts are below consensus. At some point fiscal issues will have to be dealt with in the United States, which will pressure consumer spending patterns, especially for higher-margin discretionary items.

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Morningstar Analysts does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.