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Wal-Mart’s (WMT, news, msgs) incredible string of quarterly profit growth ended Tuesday, when the giant retailer said its profit fell for the first time in over a decade. While the decline was something new, the reasons for the company’s generally sluggish performance were not.

Thanks to an $863 million charge related to its pull-out from Germany, Wal-Mart’s profit fell 26% from a year ago to $2.1 billion. Earnings from continuing operations -- a key metric for Wall Street -- rose 5% to $2.98 billion, or 72 cents per share. Sales rose 11% to $85.4 billion, slightly below Wall Street estimates.

However, there were some on the Street who took umbrage with the numbers, pointing out that Wal-Mart included units that it is selling as discontinued operations. The decision to classify some of its stores that way bolstered per-share earnings by three cents. According to Charles Grom, an analyst with J.P. Morgan, Wal-Mart would have missed its earnings without the accounting sleight-of-hand.

How can Wal-Mart grow?
Questions about the quality of Wal-Mart’s earnings played a role in the stock’s modest decline Tuesday. Yet the more pressing concern for average investors is how Wal-Mart can rejuvenate profit growth in a relatively hostile environment for retailers.

Management wasted no time in blaming gas prices for its “disappointing” sales figures. Given that the company’s relatively low-income customer base is particularly sensitive to increases in fuel prices, the rise in energy prices has been a handy crutch for Wal-Mart to lean on for any disappointments within its numbers. But all retailers are facing the same issue and many -- J.C. Penney (JCP, news, msgs) and Kohl’s (KSS, news, msgs) for example -- are delivering much more growth.

Wal-Mart’s troubles extend beyond higher gas and utility prices: the retailer is struggling to redefine its image by bolstering customer service, improving employee relations and expanding its scope of higher-end merchandise. All of these efforts cost money and sales have not grown fast enough to compensate for the hit to profit margins, which fell 24 basis points in the quarter.

Undaunted, Wal-Mart has accelerated its plan to update its existing stores. The company plans to remodel 1,800 stores over the next 18 months. Compared to the 300 or so stores the company has redone annually over the past few years and you can see that management remains resolute in its effort to reposition Wal-Mart for the long-term by upgrading its product offerings to more closely resemble those at the more upscale Target (TGT, news, msgs).

More downward surprises ahead?
Surprisingly, Wal-Mart didn’t lower its guidance for the second half of the year despite the near record oil prices and the aggressive face-lift plan. The company still sees earnings of 59 to 63 cents in the third quarter and a full-year profit of between $2.88 and $2.95. While remodeling should drag on sales in the next 6 to 12 months, it should eventually pay off.

It is possible that management will be forced to guide its numbers lower, especially if the macroeconomic conditions continue to deteriorate heading into the ever important holiday shopping season. Yet CEO Lee Scott has been around the retailing game long enough to understand the American appetite for spending, and given Wal-Mart’s competitive pricing it should weather the economic storm as well as most other big box retailers.

Sales and earnings growth might not be in the teens again any time soon, but they should be good enough to support the stock’s current valuation. Wal-Mart trades at roughly 15-times estimated earnings for the current year and 13.6-times next year’s projected gain of $3.29 -- slightly below the industry averages. Yet Wal-Mart remains a StreetPatrol portfolio holding with a target of $54.

When macro conditions improve and the store remodeling efforts near completion, the surprises out of Wal-Mart will turn from negative to positive, resulting in modest multiple expansion and meaningful stock appreciation.
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