Wal-Mart Shops for Nobody

 | Sep 19, 2011 | 4:00 PM EDT
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For as long as I have covered Wal-Mart (WMT), a rumor has circled it like vultures around dead cattle in the desert. Given the ongoing population shift from the suburbs to urban settings, the massive number of baby boomers nearing retirement, a permanent underclass having been created from years of income inequality and the era of cheap gas going away, it has long been thought that Wal-Mart would go hunting for a dollar store acquisition in the U.S.

Recently, my friend and CNBC "Fast Money" trader Patty Edwards brought the topic back into the limelight by noting first, "I've often thought Wal-Mart should open smaller stores in convenient locations," and then regarding Family Dollar (FDO), "The valuation is not out of reach." Patty is truly one of the good ones in the shark-infested, investment advisor waters and knows the retail sector's nuances better than many sell-siders. While she didn't exactly say that Wal-Mart will do a deal, it is important to present the other side of what was insinuated. I think Wal-Mart will refrain from doing a dollar-store deal in the medium term and here is why.

The Time to Strike was 10 Years Ago

Wal-Mart was too infatuated with its own greatness 10 years ago to realize the longer-term changes in the macro environment were likely to give rise to dollar-store dominance in the future. Am I surprised by this lack of foresight? Nope. Wal-Mart considers itself the best creation since the wheel, and 10 years ago it was focused on gulping up the low-hanging fruit in suburban America by dotting the landscape with humungous supercenters.

Now, with vastly improved shopping experiences and a significant tailwind to earnings as a result of the macro factors I outlined, dollar stores have market caps well north of $5 billion. To land a dollar store, which holds the aces so to speak, Wal-Mart would have to offer a material premium that would set off all sorts of dominos.

The Financial Nuances

Say Wal-Mart were to come out on a Monday morning and make public a bid of $7.5 billion for Family Dollar, $500 million more than Nelson Peltz's Trian offered in March of this year, that proposed price would be funded in large part by debt issuance. Wal-Mart only had $8 billion in cash and equivalents at the end of the second quarter. Conceivably, Wal-Mart's presently stellar, long-term debt and commercial paper ratings would be placed under review for downgrade, which would raise the cost of capital for not only the Family Dollar transaction, but for future international growth initiatives and shareholder-friendly actions (share repurchases and dividend increases).

This is a big risk for Wal-Mart at this point in its earnings life, even with a Family Dollar being an operating segment, it is unlikely to go gangbusters due to a mature U.S. store base, high interest expense, rising China sourcing inflation and an international operation that will always have kinks in the armor. Wal-Mart's debt-to-equity ratio in the second quarter was 62%. Last year, I wrote that the long-term debt and commercial paper ratings were at risk minus a U.S. transaction. Imagine what will happen with a deal approaching $8 billion.

International and Express Have Wal-Mart's Heart

The purchase of South Africa's Massmart and resolving operating issues in many international areas have filled Wal-Mart's plate. International has been a challenge (outside of Asda in the U.K.) for Wal-Mart due to differing consumer preferences per country and per the various cities in those countries. That said, Wal-Mart views international as its largest growth opportunity, and is devoting a ton of capital to making it successful.

In the U.S., Wal-Mart is beginning to aggressively open its smaller format Express stores, which resemble a cross between a CVS (CVS) and a dollar store. I have walked through an Express, and I think Wal-Mart is on to something that could be a share gainer in the U.S. during the next 10 years. My sense is that Wal-Mart remains more inclined to build a fresh banner in Express, knowing the business from the start, rather than buying a dollar store where there could be skeletons in the closet, despite a thorough due diligence process. Think of it as buying a new car as opposed to a used car.

Ego and Pride

Without delving into a Wal-Mart history lesson (however, if you want to buy me a coffee and chat, I could give you that history lesson), the company culture implies that nothing is wrong (even though U.S. comparable-store sales were down for nine straight quarters) and nothing will ever be wrong. Remember that Wal-Mart was built on destroying competition via low prices and then spreading that model aggressively, not by purchasing chains and rebranding them.

The only reason Wal-Mart has opted to buy pre-existing formats internationally, such as Seiyu in Japan and Asda, is to gain instant credibility in challenging retail markets. If Wal-Mart were to buy a dollar store, it would be admitting that it has ceded its position to rivals in the U.S., something that would make Sam Walton turn in his grave.


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