STAPLES RETAILING

Food & Drug Chains Market Weight

Broadlines Market Weight
Healthy Lifestyle Market Overweight

February 6, 2014

Valuation. Our CY14 YE price target of $69 is approx. 12.0x our FY16
EPS est. of $5.78, which is 35 below the Street. The multiple is approx.
one turn below WMTs 3- and 5-year averages. With our subdued 5-yr.
EPS CAGR of 5%, we believe the discount in the multiple is warranted.
2013A

2014E

14 Prior

2015E

15 Prior

2016E

16 Prior

Q1

$1.09

$1.14A

$1.23

Q2

$1.18

$1.25A

$1.32

Q3

$1.10

$1.14A

$1.22

Q4

$1.67

$1.59E

$1.65

$1.71

FY (Jan 31)

$5.04

$5.11E

$5.17

$5.48

$5.69

$5.78

$6.13

$5.12E

$5.20

$5.57

$5.69

$6.13

$6.26

FY EPS

Consensus

3%

S&P 500

-5%

16%

Est. ($M)

FY13A

FY14E

FY15E

Revenue

$469.1

$475.4

$491.9

EBITDA

$36.4

$37.0

$38.2

EBIT

$27.9

$28.1

$29.1

$81
$76
$71

02-14

$66

12-13

Reestablishing price leadership will hurta lot. WMT needs to invest

at least $2.5 billion, we estimate, to regain its price advantage in
consumables, which could impact EPS by upwards of $0.50 in FY16.
While we are not sure WMT is ready, at some point a viable plan needs to
be developed to regain its competitive standing (see pg. 20 for our ideas).

LTM

-7%

10-13

With blood in the water, sharks are circling. We see four main threats:
traditional supermarkets, online retailers, WMTs own e-commerce efforts
and government/labor groups. If management keeps the status quo, sales
will likely be subpar, and could lead to asset deleverage over time.

YTD

WMT

08-13

Wal-Mart is losing its main competitive advantage of price

leadership. WMTs core advantage of pricing has been eroding and our
research suggests over 70% of sales are in categories where competitors
are at/near price parity. While this has been driven by some poor strategic
decisions as well as some unique challenges, it has nevertheless allowed
competitors to diminish Wal-Marts main competitive advantage.

Price Performance

06-13

Investment conclusion. According to our research, WMT is losing its

competitive advantage of pricing in the U.S. and we are downgrading the
equity to Underperform. Indeed, the loss of price leadership on everyday
items threatens the main traffic driver to WMTs stores. At the same time,
slow growth internationally and elevated corporate SG&A due to ecommerce and regulatory/compliance costs continue to weigh on results.

04-13

Under Siege - Downgrading to Underperform

Trading and Fundamental Data

Target Price (YE 14)
$69.00
Current Price
$72.87
52 Week Range
$68 - $81
Market Cap. ($mm)
$235,791
Shares Out. (mm)
3,236
Net Debt ($mm)
$53,086
ROIC (Current Yr.)
12.9%
Dividend Yield
2.6%
Avg Daily Vol (000)
6,266

02-13

W
ALhere
-MtoART
TORES INC.
Click
enter S
text.
(WMT$72.87 Underperform)

Source: Cap IQ/Wolfe Research

Scott Mushkin
(646) 582-9250
smushkin@wolferesearch.com
Michael Otway
(646) 582-9252
motway@wolferesearch.com
Brian Cullinane
(646) 582-9253
bcullinane@wolferesearch.com

Source: Wolfe Research estimates, company filings, Thomson.

DO NOT FORWARD DO NOT DISTRIBUTE DOCUMENT CAN ONLY BE PRINTED TWICE

This report is limited solely for the use of clients of Wolfe Research. Please refer to the DISCLOSURE SECTION located at the end of
this report for Analyst Certifications, Important Disclosures and Other Disclosures.
WolfeResearch.com

Page 1 of 25

Wal-Mart Stores Inc.

February 6, 2014

Investment Conclusion
Under siege While we have always been a great admirer of Wal-Mart, it is becoming clear through our
research that the company is losing its main competitive advantage of price leadership in its core U.S. market
and we are therefore downgrading the equity to Underperform from Peer Perform. Indeed, Wal-Marts U.S.
business is facing a serious, structural dilemma the companys core, historical, low-price advantage has
been eroding in recent years, according to our proprietary pricing surveys. This loss of price leadership
threatens the main consumer traffic driver to its flagship supercenter format (having the lowest prices on
everyday essentials) and we believe is partially responsible for the recent negative traffic trends. Another
growing contributor to Wal-Marts traffic challenges is increasing consumer willingness to purchase everyday
household items online for home delivery, according to our proprietary survey of female shoppers. These two
factors in combination, in our opinion, are likely to reduce store visits, depress sales and weigh on ROIC for the
foreseeable future in the U.S. Internationally, slow economic growth in certain of the companys operating
regions as well as the recent U.S. dollar appreciation both suggest a low likelihood that the International
business can mitigate the headwinds in the U.S in the near-term. Finally, given our view of a more subdued
sales growth outlook for Wal-Mart, the potential for the company to off-set the sales headwinds through
controlling SG&A becomes increasingly challenging, especially with e-commerce spending and
compliance/regulatory costs, which look to remain elevated over the coming years.
We are downgrading WMT to Underperform from Peer Perform and establishing a CY14 year-end price
target of $69. Wal-Mart is currently trading at 13.4x NTM consensus EPS, which is below the companys 1year avg. of 14.0x, but above its 3- and 5-year averages of 13.1x and 13.2x, respectively. Our CY14 year-end
price target is based on approx. 12.0x our downwardly revised FY16 (effectively CY15) EPS estimate of $5.78
(from $6.13). This compares to our previous fair value estimate for WMT shares in the low-to-mid $80s which
was driven by a 13.5x P/E multiple (midpoint of 13-14x). While WMT does not look overly expensive from a
historical context, we believe that the longer-term, structural hurdles facing the U.S. business and the erosion
of the companys price advantage will pressure sales and earnings growth over the next several years,
warranting a lower multiple. In addition, we have lowered our long-term EPS growth rate (5-year CAGR) to 5%
from 7%, mostly due to our lower sales outlook for the U.S. As such, we believe a multiple discount is
warranted and have applied a 12.0x P/E multiple to our FY16 EPS to arrive at our target price of $69. We
would note that this is roughly a 1-turn multiple discount to the companys 3- and 5-year historical NTM P/E
averages, with every half a turn below our 12.0x multiple target worth approximately $3 to the equity value.
WMTs equity underperformed the market in 2013 and we anticipate a continuation of this trend in
2014. WMTs equity rose 15.3% in calendar 2013, which was below the 29.6% return in the S&P 500 and also
below the return for our Wolfe Research Staples Index of 23.7%. Since the start of the new year, Wal-Marts
equity has continued to underperform the market and is down -7.4%, vs. the -5.2% return of the S&P 500 and
the -6.9% return of our Staples Index.

WolfeResearch.com

Page 2 of 25

Wal-Mart Stores Inc.

February 6, 2014

An analysis of next six month equity performance at current trading multiples shows no historical
near-term relative equity outperformance in WMT shares. As seen in Exhibit 1 below, a historical equity
return analysis of WMT since 2000 when the equity has traded in the multiple range of 12.0x-13.99x shows
equity returns of roughly 8% on an absolute basis over the ensuing 6 months. However, relative performance
to the S&P 500 index has been more muted and the stock has only averaged flat returns over the same time
period when in the aforementioned P/E multiple range, suggesting an additional reason not to own WMTs
equity over the next six months.
Exhibit 1: WMT: Historical P/E and Weighted Avg. Return Analysis Since 2000

Current NTM P/E: 13.4x

Stats by P/E Range

Days Return in Each Range is Positive

Days Return in Each Range is Negative
Total Days in Range
Percent of Days in Range

Absolute Performance
10.0x 11.99x

12.0x 13.99x

14.0x 15.99x

Relative Performance to S&P 500

16.0x 17.99x

10.0x 11.99x

12.0x 13.99x

14.0x 15.99x

16.0x 17.99x

129
18
147
4%

605
157
762
23%

345
425
770
24%

63
233
296
9%

99
48
147
4%

258
506
764
23%

238
534
772
24%

120
176
296
9%

Percent of Days Return is Positive

Percent of Days Return is Negative

88%
12%

79%
21%

45%
55%

21%
79%

67%
33%

34%
66%

31%
69%

41%
59%

Average Return of Positive Performance

Average Return of Negative Performance
Weighted Average 6-Month Performance

12%
-1%
11%

10%
-3%
8%

9%
-5%
1%

2%
-6%
-5%

11%
-6%
6%

15%
-8%
-0%

-10%
-7%

20%
-7%
4%

Source: Capital IQ, Wolfe Research

Our DCF analysis now incorporates the potential impact of the long-term structural challenges we see
in the business, suggesting less intrinsic value and a lower sales/margin environment. While we have
previously quantified what operating margin erosion could mean to our DCF given some of these structural
hurdles, we have now incorporated the potential impact of this into the modela continued erosion of U.S.
comp sales and margins for the foreseeable future. As such, our estimate of intrinsic value now stands at
approximately $81. While this is above our target price of $69, we believe that it is likely WMTs equity will
trade at a discount to intrinsic value due to near-term earnings pressures and business model uncertainty.
Under this forecast, we have modeled net sales growth of approximately 3% on average over the life of the
DCF model and a TV growth rate of 1.2%. The lower growth rate is again driven by comp sales weakness in
the U.S. operations and the increasing difficulty with which it will be to leverage costs under this scenario,
according to our analysis. We also estimate consolidated EBIT margin for the company declines from the
current 5.9% margin we estimate for FY14 to 5.3% in the terminal year. We utilize a weighted avg. cost of
capital of 7.2% and a tax rate of 32.0%.

WolfeResearch.com

Page 3 of 25

Wal-Mart Stores Inc.

February 6, 2014

Risks
1) The biggest risk to our Underperform call would be a significant slowdown or curtailment of
corporate SG&A (e-commerce spending, regulatory/compliance costs) allowing Wal-Mart to reestablish U.S. price gaps in grocery/consumables without a material impact to profitability.
2) A strong balance sheet provides added flexibility. Wal-Marts ability to leverage its strong balance
sheet to create additional shareholder value through increased dividends and/or share repurchases is also
a risk to our Underperform rating. However, such moves could jeopardize the companys AA credit rating,
we believe. As of the end of 3Q14, leverage stood at 1.7x LTM EBITDA. Adding in leases, (total debt + PV
of operating leases) / LTM EBITDAR was slightly higher at 1.9x. This is healthy, although not too different
from Krogers 2.0x before it purchased Harris Teeter. Krogers rating is BBB by Standard & Poors.
Granted, KR does have multi-employer union obligations that are not included in this calculation, but even
so, additional leverage could cost WMT its credit ratings.
3) Wal-Marts equity has historically been a relative safe haven during more challenging economic
timesbut the safety trade is looking less and less compelling, in our opinion. According to our
research, WMTs equity performance has the highest negative correlation with change in net worth and
GDP, more than that of Kroger or the dollar stores. This has been driven by the stable nature of Wal-Marts
business selling everyday essentials, but more importantly, selling them at low prices. This focus on
everyday low price (EDLP) has historically helped drive share gains during periods of economic weakness.
However, with the price advantage for Wal-Mart shrinking in the U.S. consumables business, according to
our research, we would put forward that Wal-Mart is less likely to see outsized volume gains during more
difficult times. In fact, Kroger for example has used the years following the great recession to invest in price
across its business. Simply looking at each companys respective comp sales over the last few years tells a
compelling story (bullish for KR and bearish for WMT). See Exhibit 4. While WMTs equity will likely remain
a beneficiary of the safety trade during periods of economic weakness as investors flock to stability, we
would argue that the more compelling safety trade is KR, whose business has gotten stronger in recent
years.
Exhibit 2: Relative Equity Performance in the Period Leading Up to and Through the Great Recession

150

130
110
90
70
50
30

WMT

KR

S&P 500

Note: Prices for WMT, KR and the S&P 500 are indexed to August 31, 2007.
Source: Capital IQ

WolfeResearch.com

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Wal-Mart Stores Inc.

February 6, 2014
Exhibit 3: Wolfe Research Economic and Statistical Analysis: Correlations of Wal-Mart and Kroger vs. Macroeconomic Data

Correlations
Wal-Mart U.S. Comps
WMT Performance
WMT Relative Performance

U.S.
Y/Y Change
Employment in Employment
Rate
Rate
0.58
0.15
(0.17)
0.14
0.05
(0.35)

Kroger Ex-Fuel Comps

KR Performance
KR Relative Performance

0.76
0.20
0.37

Households &
Univ. of
Nonprofit
Michigan
Nominal Avg.
Organizations
Consumer
Weekly
Food at Home
Net Worth Real GDP Y/Y
Sentiment
Earnings
CPI
(y/y change)
Change
(0.06)
0.39
0.68
(0.31)
(0.20)
(0.25)
0.23
0.31
(0.06)
(0.12)
(0.38)
0.06
0.43
(0.76)
(0.61)

0.50
0.52
0.12

0.33
0.21
(0.00)

0.79
0.36
0.27

0.67
0.15
0.39

0.13
0.46
(0.24)

(0.02)
0.18
(0.35)

Note: Data set used in analysis is quarterly beginning in 1Q04 (Jan. 1, 2004) through most current reported quarter.
Source: Wolfe Research, company data, Capital IQ, Haver Analytics, Bureau of Labor Statistics, University of Michigan, Federal Reserve Board

Exhibit 4: Comparable Store Sales (KR and WMT)

1Q08
2Q08
3Q08
4Q08
1Q09
2Q09
3Q09
4Q09
1Q10
2Q10
3Q10
4Q10
1Q11
2Q11
3Q11
4Q11
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13

7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
-3.0%
-4.0%

KR Ex-fuel IDs

WMT US Comps

Note: ID sales for KR exclude fuel. Comp sales for both companies are presented in the closest calendar quarter for comparability.
Source: Wolfe Research, company filings

4) Valuation is not overly expensive. Wal-Mart is currently trading at 13.4x NTM consensus EPS, which is
below the companys 1-year average of 14.0x, but slightly above the companys 3- and 5-year averages of
13.1x and 13.2x, respectively. Clearly from a historical context, WMTs equity does not appear expensive,
as it is roughly a half-turn below its 1-year average and trading at only slight premiums to its longer-term
averages. In addition, our DCF does suggest an intrinsic value of approximately $81. However, relative to
KR, which is trading at 11.7x NTM consensus EPS, WMTs current multiple is over a turn and a half higher.
We believe WMTs valuation premium to KR is unjustified in large part due to the trajectory of the
respective businesses with KRs business having come out of the great recession stronger and taking
market share, while Wal-Marts U.S. business has remained challenged of late.

WolfeResearch.com

Page 5 of 25

Wal-Mart Stores Inc.

February 6, 2014

Key Earnings Drivers and Outlook

Our revised outlook for Wal-Marts 4Q14 largely reflects the continued challenging sales climate in the
U.S. as well as the currency headwinds abroad. For Walmart U.S., we have lowered our 4Q comp estimate
to -0.5% from +0.25%. We have also taken our Sams Club comp estimate to flat from +1.5%. With respect to
the International business, our sales forecast has been reduced to reflect an estimate for currency, last weeks
announcement of store closures in Brazil and China, as well as a 50 bp reduction in our comp sales forecast.
We now estimate 4Q14 EPS (ex. items) of $1.59 (down from $1.65), which is below the Streets $1.60.
Our longer-term forecast reflects the structural hurdles we see with Wal-Marts U.S. operations. While
food stamp cuts, payroll tax increases, consumers uncertainty around healthcare costs, sluggish employment
trends and low inflation are indeed factors which are contributing to weaker sales at Wal-Mart, we believe the
underlying traffic challenges go deeper and also have to do with the gradual erosion of the companys
namesake price advantage in recent years. To that end, without some change in this positioning, we see little
reason to believe the weaker traffic and sales trends are to change in the foreseeable future. As such, we have
lowered our Walmart U.S. comp forecast for FY15 and FY16 to -0.5% (both years) from +1.5% and +1.5%,
respectively. While the company has done a good job taking costs out of the business, led by the U.S.
operations, SG&A leverage will become increasingly harder to come by over time in a climate of weaker comp
sales, in our opinion. As such, we estimate flat operating margin in the U.S. in FY15 and slight margin erosion
starting in FY16. This is down from our previous forecast which showed slight improvement of 10 bps and 5
bps over the next two years, respectively.
We have lowered our FY15 Sams Club comp forecast. Our ex-fuel comp forecast for FY15 is now 0.9%,
down from 2.0%, while our FY16 comp estimate remains unchanged at 2.0%. We forecast FY15 EBIT (ex-fuel)
margin to be up slightly y/y given the membership fee increase, although as this rolls off in FY16, we estimate
some margin pressure y/y. On the International side of the house, our revised forecast for FY15 and FY16
comp sales is 1.6% and 2.5% from 3.0% and 4.0%, respectively. With respect to corporate SG&A, while some
of the FCPA costs will likely roll-off in FY15 suggesting the potential for some slight leverage y/y, we estimate
continued upward pressure on the line-item. In FY16 and beyond, we now estimate slight upward pressure
each year in unallocated corporate costs, vs. some leverage forecasted previously given what we see as an
environment of continued ecommerce spending and higher compliance/regulatory costs. On a consolidated
basis, this all translates to lower gross margin and higher SG&A. Our EPS estimates for FY15 and FY16 are
now $5.48 and $5.78, down from $5.69 and $6.13, respectively. Our estimates for both years are 1.6% (or
$0.09) and 5.7% (or $0.35) below current Street consensus estimates.
We are also establishing a 1Q15 EPS estimate of $1.23. Our 1Q15 forecast reflects flat Walmart U.S.
comps, Sams Club comps (ex-fuel) of 1.75% and constant currency growth of 3.6% for International. On a
consolidated basis, we forecast slight gross margin pressure of 5 bps and flat SG&A expenses as a % of net
sales. We have utilized a tax rate of 32.0%. Our EPS estimate of $1.23 is a penny below current Street
estimates.

WolfeResearch.com

Page 6 of 25

Wal-Mart Stores Inc.

February 6, 2014
Exhibit 5: Comparative Annual Forecast Table ($mm, except per share data)
Fiscal Year 2015

($mm, except per share data)

Total Revenue

Fiscal Year 2015 Forecast

Wolfe
Wolfe
Research Research
Street
Current
Prior
Consensus
$491,919
$502,003
$494,142

Fiscal Year 2016

Current
vs.
Prior
Forecast
-2.0%

Current
vs.
Street
Forecast
-0.4%

Fiscal Year 2016 Forecast

Wolfe
Wolfe
Research Research
Street
Current
Prior
Consensus
$507,270
$526,147
$517,181

Current
vs.
Prior
Forecast
-3.6%

Current
vs.
Street
Forecast
-1.9%

EBIT (Operating)

$29,111

$29,881

$29,380

-2.6%

-0.9%

$29,637

$31,259

$31,030

-5.2%

-4.5%

EBITDA

$38,234

$39,007

$38,599

-2.0%

-0.9%

$39,047

$40,689

$40,503

-4.0%

-3.6%

Net Income from Continuing Ops Attributable to Wal-Mart

$17,587

$18,117

$17,749

-2.9%

-0.9%

$17,930

$19,050

$18,806

-5.9%

-4.7%

Diluted EPS from Continuing Ops Attributable to Wal-Mart

$5.48

$5.69

$5.57

-3.7%

-1.6%

$5.78

$6.13

$6.13

-5.8%

-5.7%

Walmart U.S. Comp Sales (Retail Calendar)

-0.5%

1.5%

NA

-2.0%

NA

-0.5%

1.5%

NA

-2.0%

NA

Source: Wolfe Research estimates, company filings, Thomson

Exhibit 6: Key Earnings Drivers and Outlook ($mm, except per share data)
Earnings Table: Wal-Mart Consolidated
Net Sales
Cost of Sales
Operating, Selling, General & Administrative Expenses
EBIT (Operating)
Depreciation & Amortization
EBITDA
Interest Expense, Net
EBT
Income Taxes
Net Income from Continuing Ops Attributable to Wal-Mart
Net Income from Continuing Ops Attributable to Wal-Mart (Ex. Items)

Q4:14E
$127,687
$96,633
$23,457
$8,510
$2,246
$10,756
$469
$8,041
$2,573
$5,178
$5,178

2014E
$472,208
$356,802
$90,497
$28,121
$8,846
$36,967
$2,132
$25,937
$8,439
$16,754
$16,789

2015E
$488,483
$369,370
$93,438
$29,111
$9,123
$38,234
$2,071
$27,040
$8,653
$17,587
$17,587

2016E
$503,730
$381,277
$96,355
$29,637
$9,410
$39,047
$2,020
$27,617
$8,838
$17,930
$17,930

Diluted EPS from Continuing Ops Attributable to Wal-Mart

Diluted EPS from Continuing Ops Attributable to Wal-Mart (Ex. Items)
First Call Consensus

$1.59
$1.59
$1.60

$5.10
$5.11
$5.12

$5.48
$5.48
$5.57

$5.78
$5.78
$6.13

Weighted Avg. Shares Outstanding

3,255

3,284

3,208

Growth Rates
Total Net Sales
EBIT (Operating)
EBITDA
Diluted EPS from Continuing Ops Attributable to Wal-Mart (Ex. Items)

0.5%
-1.0%
-0.2%
-4.8%

1.3%
0.8%
1.5%
1.5%

Margins
Gross Profit Margin (Ex. Membership and Other Income) (As % of Net Sales)
Operating, Selling, General & Administrative Expenses (As % of Net Sales)
EBIT (Operating) Margin
EBITDA Margin

24.3%
18.4%
6.6%
8.4%

Change in Margin
Gross Profit Margin (Ex. Membership and Other Income) (As % of Net Sales)
Operating, Selling, General & Administrative Expenses (As % of Net Sales)
EBIT (Operating) Margin
EBITDA Margin
Effective Tax Rate

-0.05%
0.13%
-0.11%
-0.06%
32.0%

Earnings Table: Wal-Mart Segment Detail

Walmart U.S.
Net Sales
EBIT (Operating)

Q4:14E

2014E

2015E

2016E

$76,016
$6,525

$278,989
$22,498

$284,123
$22,923

$289,681
$23,299

Walmart International
Constant Currency Sales
Constant Currency EBIT (Operating)

$38,915
$2,380

$140,567
$6,755

$146,488
$7,039

$153,895
$7,318

Sam's Club (Ex. Fuel)

Net Sales
EBIT (Operating)

$13,172
$509

$50,593
$2,046

$51,887
$2,137

$53,441
$2,147

Other Expense (Unallocated Corporate)

($873)

($3,015)

($2,985)

($3,129)

3,103

Retail Calendar Comp Sales

Walmart U.S. Comp
Sam's Club Comp (Ex. Fuel)

-0.5%
-

-0.6%
0.7%

-0.5%
0.9%

-0.5%
2.0%

3.4%
3.5%
3.4%
7.2%

3.1%
1.8%
2.1%
5.4%

Margins
Walmart U.S.
Walmart International (Constant Currency)
Sam's Club (Ex. Fuel)

8.6%
6.1%
3.9%

8.1%
4.8%
4.0%

8.1%
4.8%
4.1%

8.0%
4.8%
4.0%

24.4%
19.2%
5.9%
7.8%

24.4%
19.1%
5.9%
7.8%

24.3%
19.1%
5.8%
7.7%

Change in Margin
Walmart U.S.
Walmart International (Constant Currency)
Sam's Club (Ex. Fuel)

0.05%
-0.15%
0.10%

0.22%
-0.22%
0.20%

0.00%
-0.00%
0.07%

-0.03%
-0.05%
-0.10%

0.06%
0.12%
-0.03%
0.02%
32.5%

-0.06%
-0.04%
0.00%
-0.00%
32.0%

-0.08%
-0.08%
-0.07%
32.0%

Source: Wolfe Research estimates, company filings, Thomson

WolfeResearch.com

Page 7 of 25

Wal-Mart Stores Inc.

February 6, 2014

Wal-Mart is Losing its Competitive Advantage of Price Leadership

Wal-Marts core competitive strength its low price position is being challenged across a number of
markets in everyday consumables. According to our research, including our proprietary pricing surveys, the
average price premium to Wal-Mart on a basket of fast-turning/high-household penetration items has narrowed
over the last few years across a number of large U.S. markets that we visit on a regular basis. In some
markets, such as Houston, Philadelphia and Chicago, this narrowing has been more significant, with the price
premium to Wal-Mart going from double digits to low/mid-single digits on average. Looking more closely, in
Houston for example, Wal-Mart is no longer the price leader, a title that now goes to HEB as it was priced
roughly 2% below that of Wal-Mart during our recent trip to the market in January. Kroger, which competes
with Wal-Mart more than any other traditional grocery retailer, has narrowed its price gaps to Wal-Mart in
recent years, and we estimate in many instances, when taking into account Krogers direct-to-consumer
discount program and fuel rewards program, Kroger is providing many of its customers with prices at or below
those of Wal-Mart in the key consumables area. HEB and Kroger are not the only grocery retailers to have
shrunk relative price gaps to Wal-Mart, as we have seen gaps to Wal-Mart fall at certain Cerberus-owned
banners, as well as Safeway, Wegmans and Meijer, to name a few.
The erosion of Wal-Marts price advantage in consumables cannot be underestimated. In our opinion,
the narrowing of these competitive price gaps is quite troubling, especially as Wal-Mart struggles to drive better
top-line sales in the U.S. under the weight of a sluggish economic backdrop. While there are clearly factors
outside of the companys control, such as cuts to the food stamp program (SNAP), uncertainties around the
Affordable Care Act, and low inflation, all of which are conspiring to hamper comp sales growth, the bigger
issue at hand in our opinion is the ebbing of the companys pricing advantage in consumables in the U.S.,
which goes to the heart of Wal-Marts core strategic pillar low prices. The consumables price advantage is
the key driver of traffic, sales and returns for the companys flagship supercenter operations.
Without a meaningful change to this dynamic of price gap erosion, we believe it will be increasingly difficult in
the coming years for Wal-Marts U.S. business to drive sustained same-store sales and EBIT growth and this is
the crux of our downgrade to Underperform from Peer Perform.
Exhibit 7: Avg. Competitor Price Premium to Wal-Mart: Philadelphia and Houston

14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%

12.0%
10.0%

8.0%
6.0%
4.0%

2.0%
0.0%

Dec-11

Dec-12

Dec-13

Price Premium to Wal-Mart (Philadelphia)

Jan-12

Jan-13

Jan-14

Price Premium to Wal-Mart (Houston)

Note: The markets price premium is an average of the individual retailers we visit in each market. Our baskets contain fast turning and high household
penetration items. When an item is not available during our visit (cannot be found or the package size has changed), we remove this item from the
comparable basket. Philadelphia competitors include Genuardi's, Wegmans, Giant, Acme, Target and ShopRite. Houston competitors include HEB, Kroger,
Target and Randalls.
Source: Wolfe Research

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Exhibit 8: Avg. Competitor Price Premium to Wal-Mart: Chicago and Atlanta

15.0%

12.0%
10.0%

10.0%

8.0%
6.0%

5.0%

4.0%
2.0%

0.0%

0.0%
Nov-10

Dec-11

Dec-12

Dec-13

Nov-11

Price Premium to Wal-Mart (Chicago)

Nov-12

Nov-13

Price Premium to Wal-Mart (Atlanta)

Note: The markets price premium is an average of the individual retailers we visit in each market. Our baskets contain fast turning and high household
penetration items. When an item is not available during our visit (cannot be found or the package size has changed), we remove this item from the
comparable basket. Chicago competitors include Dominicks, Jewel, Meijer, Target, Marianos and Food 4 Less. Atlanta competitors include Kroger, Target
and Publix.
Source: Wolfe Research

Exhibit 9: Houston Pricing Survey: Avg. Comparable Basket (Indexed to Jan. 2013) and Current Premium/ (Discount) to Wal-Mart

1.0%

15.0%
10.5%

0.0%

10.0%

-1.0%

4.1%

5.0%
1.5%

-2.0%
0.0%
-1.9%

-3.0%

Jan
2013

Mar
2013

May
2013

July
2013

Sept
2013

Nov
2013

Houston Avg. Basket (Indexed to Jan. 2013)

Jan
2014

-5.0%
HEB

Kroger

Target

Randalls
(Safeway)
Premium/ (Discount) to Wal-Mart (Jan. 2013)

Note: The markets basket is an average of the individual retailers we visit. The percent change in the basket is compared to a base basket from the year
ago time period. Our baskets contain fast turning and high household penetration items. When an item is not available during our visit (cannot be found or
the package size has changed), we remove this item from the comparable basket.
Source: Wolfe Research

Our proprietary pricing surveys have been some of our most reliable data. Developed during the last
decade in consultation with many industry contacts and refined over the last several years, our surveys focus
on roughly 75 fast-turning and/or high household penetration items such as milk, Cheerios and Tide.
Concentrating on fast-turning/high household penetration products provides a good measure on how
consumers perceive a chains price position versus others in an area and it also reveals the competitive
conditions in a market. We monitor six cities, including Los Angeles, Houston, Atlanta, Chicago, Philadelphia
and Washington D.C., visiting three cities one month and the other three the next month. We visit one store per
chain per market; however we do spot check other stores in a chain occasionally to make sure the data set is
consistent. All the research is done directly by the Wolfe Research Staples Retailing team and no outside
vendors help us collect the data. The reason for this methodology is that there can be various nuances when
recording prices that third parties have troubling discerning. In addition, being in stores often helps in other
areas of our research such as understanding store execution. The prices recorded are the lowest available
shelf price. For traditional supermarkets, this includes frequent shopper deals, but excludes any direct to
consumer coupons and gasoline discounts.
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Wal-Mart Stores Inc.

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The issue of lost price leadership, however, is not just in consumables. Although consumables do make
up 55% of the companys sales and are the main reason many shoppers visit Wal-Marts flagship supercenter
operations, our snap-shot survey of electronic and media items also found little price difference between WalMart, Best Buy and Amazon. When these items are added to the consumables area, roughly 66% of WalMarts sales volumes are in merchandise where consumers can find similar pricing at other outlets. The price
issue does not end here, however, as structural changes in the pharmacy business (more customers having
insurance coverage) have diminished the value of direct-to-consumer low prices for pharmaceuticals. While
prescription drugs do not make up all of the 11% of sales Wal-Mart classifies as health and wellness, we
believe it is the majority. Adding this category to consumables, media and electronics brings the percentage of
items sold at Wal-Mart where the company no longer exhibits pricing advantages to over 70%.
Exhibit 10: Electronics Pricing Survey and Electronics & Media Pricing Survey

$3,950

$4,050
$3,830.91

$3,850

$3,850

$3,750

$3,750
$3,650

$3,932.87

$3,950

$3,583.74

$3,586.78
$3,539.88

$3,550

$3,684.77

$3,682.14

Walmart

Amazon

$3,650
$3,550

$3,450

$3,450
$3,350

$3,350
Walmart

Amazon

Target

Electronics Pricing Survey Basket

Best Buy

Target

Electronics & Media Pricing Survey Basket

Note: These surveys were conducted using the online stores for Walmart, Amazon, Target & Best Buy. Each basket contains the exact same items. Our
electronics pricing survey basket includes 12 top selling items including: Apple iPad, Samsung LED TV, Xbox One, Beats by Dr. Dre headphones, Google
Chromecast, Grand Theft Auto V, and Twilight Saga: Breaking Dawn Part 2 DVD, to name a few. The Electronics & Media/Toys basket includes the same
items in the electronics basket, as well as several toys, a Monopoly board game and a top-selling book.
Source: Wolfe Research

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Wal-Mart Stores Inc.

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Three Strategic Decisions and a Challenge Have Led to the Diminishing of Price Leadership in
the U.S.
Decision #1: Letting margins rise in the U.S. Wal-Marts U.S. business has seen its operating margin move
higher over the years, despite its increasing mix of consumables and higher corporate SG&A spending. The
company has grown its grocery business (food and consumables) to 55% of net sales in the U.S., up from 47%
in 2008. This has undoubtedly placed downward pressure on profit margins given the lower relative margin
from these types of items. We estimate corporate SG&A spending will rise to approximately $3 billion in
FY14E, up roughly $1 billion from just two years ago. That said, Wal-Mart has taken substantial costs out of
the system, particularly in the U.S., a feat they have accomplished even during certain years of difficult sales. It
is this squeezing of costs which has been largely responsible for driving the operating margin improvement in
the U.S., but it has also been responsible, we believe, for some execution issues that have developed (see
discussion on Page 14).
Exhibit 11: Walmart U.S. FY13 % of Net Sales by Category and Grocery Sales as % of Total
Apparel
7%

Home
7%

56%
54%

53%

53%

2010A

2011A

55%

55%

2012A

2013A

52%

Hardlines
9%

50%

49%

48%

47%

46%

Health &
Wellness
11%

Grocery
55%

44%
42%
2008A

Entertainment
11%

2009A

% of Net Sales by Category (Grocery)

Source: Company filings

Exhibit 12: Walmart U.S. EBIT Margin

8.0%
7.8%
7.6%
7.4%

7.2%
7.0%
2008A

2009A

2010A

2011A

2012A

2013A

Walmart U.S. EBIT Margin

Source: Wolfe Research, company filings.

WolfeResearch.com

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Wal-Mart Stores Inc.

February 6, 2014

Decision #2: Chasing online retailers: Wal-Mart is making substantial investments to grow its e-commerce
platform and has noted that this would depress EPS this fiscal year by an incremental $0.10. While the
incremental investment in FY15 should be less than in FY14, our read is that spending in this area is likely to
remain elevated over the coming years as e-commerce becomes an increasingly important channel for
consumer spending. That said, we have concerns that this spending not only puts pressure on Walmart U.S. to
deliver earnings, but may also cannibalize sales from the current store base, pressure asset productivity and
ROIC.
Decision #3: International expansion: Wal-Marts move overseas has seen mixed results over a long period
of time, with noteworthy trouble areas including Germany, Japan, and more recently headwinds in China and
Brazil where the company has elected to shutter stores. And while the promise of faster growth internationally
has proven seductive, the results as well as the benefits to shareholders are much less clear, in our opinion.
What has been clear is that the companys foreign operations are performing below expectations and have
been responsible for much of the increase in regulatory spending over the last 12-18 months due to FCPA
(Foreign Corrupt Practices Act) issues. With little change expected in this dynamic over the next 6-12 months,
the pressure again falls on Wal-Marts large U.S. operations to deliver EBIT.
The Challenge: The size of the company makes it a target of the government and labor advocacy
groups. As Wal-Mart has gotten bigger, so too have its headaches regarding its labor and business practices.
Today, Wal-Mart spends a good deal of time and money in hopes of easing Washington scrutiny, bolstering its
corporate image and assuaging labor groups. But the more Wal-Mart gives, the more these groups seem to
want, suggesting a never-ending spiral in corporate SG&A expenses. For example, just as the company hoped
to be putting the worst of the FCPA and compliance-related costs behind it, the NLRB (National Labor
Relations Board) has started procedures against the company. This is real money: costs for the FCPA and
related regulatory/compliance enhancements have amounted to $224mm in FY14 YTD and are anticipated to
total upwards of $300mm for the full year. Of the $224mm in costs thus far, we expect about 40% to be
recurring.
From FCPA to NLRB. As mentioned, in mid-January of this year the NLRB filed a complaint against Wal-Mart
regarding employee rights. The issue revolves around attempts to unionize Wal-Marts operations and
activities by certain employees to participate in random work-stoppages to protest Wal-Marts pay and working
conditions. It appears that the NLRB wants to push the action against WMT as a test case for these types of
employee actions. While time will tell what will come of the above complaint by the NLRB, we simply take it as
another signal that upward pressure is likely to remain on the expense line for the foreseeable future. In FY15,
we are anticipating unallocated corporate dollars to remain flattish around $3 billion, given a decrease of
certain FCPA-related costs, but a rise in other related costs. That said, the unallocated expense bucket is
somewhat of a catchall for many ancillary corporate costs and remains difficult to forecast.

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February 6, 2014
Exhibit 13: Unallocated Corporate Expense ($mm) and Y/Y Change
$3,500

30.0%
25.0%

$3,000
20.0%

$2,500

15.0%

$2,000

10.0%
5.0%

$1,500
$1,000

-5.0%

2011A

2012A

2013A

Unallocated Corporate Expense

2014E
Y/Y Change

Source: Wolfe Research estimates, company filings

These Strategic Decisions and the Challenge Have Created a Great Need for U.S. EBIT
Turning lemons into lemonade. Bill Simon (EVP, President and CEO, Walmart U.S.) has been under
pressure in recent years to produce EBIT and lower costs given the swift acceleration of expenses in corporate
SG&A and he delivered on that goal. In fact, EBIT growth in the U.S. has outstripped sales growth since
2010, even when sales have disappointed. While better productivity is usually a good thing, Wal-Marts has
come despite stagnant sales per square ft. over the last few years. With many costs fixed, normally higher
productivity in a retail company comes from leveraging better sales per square foot over the fixed asset base.
This has not been the case for Wal-Mart, as better productivity has come from driving down more variable
expenses. This is not always bad, but for Wal-Mart it appears to have led to some spotty execution, further
opening the door to competitors, in our opinion.
Exhibit 14: Walmart U.S. Sales / Sq. Foot and EBIT / Sq. Foot
$436

$35

$434

$35

$432

$34

$430

$34

$428
$33

$426

$33

$424

$32

$422

$32

$420
2012A

2013A
U.S. Sales / Sq. Foot

2014E

2012A

2013A

2014E

U.S. EBIT / Sq. Foot

Source: Wolfe Research estimates, company filings

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Wal-Mart Stores Inc.

February 6, 2014

The need for cost savings has caused execution to suffer, in our opinion. Walmart U.S.s relentless focus
on costs does seem to have taken some toll on in-store conditions and stock levels. This is clearly an area that
is subject to differences of opinion, and it is easier to be forgiven by customers when a lot of money is being
saved, but our store visits over the last six months show a repeating pattern of stocking issues in many
departments in the store. This creates a couple of issues: first, if an item is not on the shelf, you cannot sell it,
so out-of-stocks depress sales. Second, if the stores are out-of-stock, with long cash register lines and prices
that are just in-line with other retailers there really is no reason for consumers to shop the store.
Exhibit 15: Wal-Mart Out-of-Stocks

Source: Wolfe Research

Could more labor help solve the execution issues potentially. SG&A savings, at least to some degree,
appear to have come from lowering the amount of labor in the stores. While this is not necessarily a bad thing
as it may indicate that Wal-Mart is improving business practices and can now deploy less labor to get the same
results, the spotty store conditions and execution suggest at least some of the reduction in labor has led to
operational issues.
Exhibit 16: Walmart U.S. Employees and Square Footage (in thousands)
1,450

750,000

1,425

725,000

1,400

700,000

1,375

675,000

1,350
650,000

1,325

625,000

1,300

600,000

1,275
1,250

575,000
2007A

2008A

2009A

Total U.S. Sq. Footage

2010A

2011A

2012A

2013A

Approximate # of U.S. Employees

Source: Wolfe Research, company filings

WolfeResearch.com

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Wal-Mart Stores Inc.

February 6, 2014

These Dynamics Are Leading to Four Main Threats to Wal-Marts Core U.S. Business
With blood in the water, the sharks are circling there appear to be four main threats to Wal-Marts U.S.
business: 1) The traditional supermarkets (both good operators and historically weaker ones) have reduced
their price gaps to Wal-Mart in recent years; 2) Online retailers; 3) Wal-Marts own e-commerce business which
is cannibalizing Wal-Marts retail stores; 4) Government / labor groups.
The traditional supermarkets: Wal-Mart, as discussed earlier in the report, has let its price leadership in the
key consumables area be eroded by superior traditional operators such as HEB, Wegmans and Kroger. This
dynamic has been going on for years, but has seemingly accelerated during the last three. The best example
of this is with Kroger, Wal-Marts biggest competitor in the U.S. consumables market.
A look at Krogers margins tells a compelling story one that is not so good for Wal-Mart. Years of
price investment by Kroger have helped the company narrow/eliminate its price gap to Wal-Mart. As we have
noted, including Krogers direct-to-consumer discounting and fuel rewards programs, we believe KR is priced
at or below Wal-Mart in many markets on consumables. This has not always been the case, but is rather due
to years of price investments and a lot of profit pain too. However, Krogers efforts to sharpen prices over the
last decade have put the company in an advantageous competitive position and one that is clearly leading to
sales and market share gains.
Exhibit 17: Comparable Basket in Houston (Wal-Mart and Kroger) and Krogers EBIT Margin
$185.00

3.4%

3.2%
$175.00

3.0%
2.8%

$165.00

2.6%
$155.00

2.4%
2.2%

Wal-Mart

Kroger

Jan-14

Oct-13

Jul-13

Jan-13

Apr-13

Oct-12

Jul-12

Jan-12

Apr-12

Oct-11

Jul-11

Jan-11

Apr-11

Jul-10

Oct-10

Jan-10

Apr-10

Oct-09

$145.00

2.0%
2008A

2009A

2010A

2011A

2012A

2013A

Kroger EBIT Margin (w/ Fuel)

Note: The baskets above contain the exact same 50 fast turning and high household penetration items over the time frame shown. When an item is not
available during our visit (cannot be found or the package size has changed), we remove this item from the comparable basket. Ex fuel, Krogers FIFO EBIT
margin in FY11, FY12 and FY13, was 2.9%, 3.1% and 3.2%, respectively. On average over the last 3 years, the delta between KRs w/fuel EBIT margin and
ex-fuel margin was roughly 40 bps.
Source: Wolfe Research, company filings

Its not only the strong operators that are challenging the mighty Wal-Mart, but some of the historically
weaker ones as well. Over the last 12-24 months, other, generally weaker, traditional operators such as the
Cerberus-owned operations and Delhaize have aggressively lowered prices and appear to be seeing good
results (at least on volume). A chart can say a thousand words and the chart in Exhibit 18 on the next page of
the Chicago market certainly meets the goal. In Chicago, the average price gap to Wal-Mart has compressed
rapidly with most competitors now below 5%. Jewel, once the consistent high price option in Chicago,
frequently with prices 20% over Wal-Mart, is now down to roughly 2% over Wal-Mart in our December survey.
Our data strongly indicates shoppers are noticing the lower prices, with many of the chains that have invested
in price seeing good, positive volume growth, while WMT is now seeing negative comp store dry grocery
volumes, according to our industry sources.
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February 6, 2014
Exhibit 18: Avg. Competitor Price Premium to Wal-Mart in Chicago and Comparable Basket in Philadelphia (Acme and Wal-Mart)
$200.00

16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%

$190.00
$180.00
$170.00
$160.00
$150.00

Price Premium to Wal-Mart (Chicago)

Acme

Sep-13

Dec-13

Jun-13

Dec-12

Mar-13

Jun-12

Sep-12

Mar-12

Sep-11

Dec-11

Jun-11

Mar-11

Dec-10

Dec-13

Jun-10

Dec-12

Sep-10

Dec-11

Dec-09

Nov-10

Mar-10

$140.00

Wal-Mart

Note: The markets basket is an average of the individual retailers we visit. The baskets above contain the exact same 50 fast turning and high household
penetration items over the time frame shown. When an item is not available during our visit (cannot be found or the package size has changed), we remove
this item from the comparable basket. Chicago competitors include Dominicks, Jewel, Meijer, Target, Marianos and Food 4 Less.
Source: Wolfe Research

Online retailers: More ubiquitous consumables appear destined to be purchased online. Our proprietary
consumer survey of women suggests that more non-perishable, everyday items may be purchased online
through companies such as Amazon over the coming years. The willingness to consider online is quite high in
categories such as household chemicals, personal care/beauty, paper/plastic products and packaged foods.
Many of these same categories are what Wal-Mart uses to drive trips to its supercenters. Retail is all about
asset productivity and this means Wal-Mart needs to increase trips to its stores, thereby increasing sales and
opportunities for additional purchases. The main avenue for doing this is attracting customers with its low
prices for frequently needed everyday items. In fact, our research suggests consumers main reason for going
to a mass merchant like Wal-Mart is to purchase these items. The more sales of these items that take place
online, the fewer the trips likely to be at the companys stores.
Exhibit 19: Which Products Would You be Interested in Buying from an Online Retailer?
Educated
Millennial

Millennial
Women (All)

General
Population

Answer
Household items (laundry detergent, cleaning products)

85.6%

87.8%

86.5%

Personal Care & Beauty items (toothpaste, deodorant, shaving items, makeup)

87.8%

82.2%

88.0%

Paper & plastic products (napkins, paper towels, plastic cups)

75.1%

81.7%

79.8%

Packaged Food (cereal, bread, snacks, ingredients, nuts)

74.6%

78.2%

71.5%

Vitamins & Supplements (sports drinks, protein bars)

71.3%

73.6%

73.3%

Over the Counter medications

56.9%

60.9%

66.9%

Baby supplies

34.3%

43.1%

22.7%

Non-alcoholic beverages (milk, soda, juices, specialty drinks)

34.3%

31.0%

28.5%

Prepared Food/Ready to Eat meals (meals made in store, store-packaged meals)

21.0%

25.9%

24.5%

Frozen Food (frozen pizza, breakfast items, frozen vegetables, dessert)

20.4%

23.4%

20.9%

Fresh Fruits & Vegetables

14.4%

12.7%

17.5%

8.8%

11.7%

14.1%

Fresh Protein - Meat, Seafood, Eggs

Note: N= 500 Educated Millennial women, 500 Millennial women, 1,000 women in general population. Millennials represent the group of the U.S. population
born between the years of 1982 and 2001. Educated Millennial women have graduated from 4 year colleges. The 500 Millennial women are a different
sample group that is spread by age (18-32), income and education level that are representative of the U.S. female population in that age range. The general
population of women is also spread across age (18-65), income and education levels that are representative of the U.S. female population.
Source: Wolfe Research

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Wal-Mart Stores Inc.

February 6, 2014

So far, WMT has a solid price advantage in grocery relative to online retailers. In fact, our pricing survey
of Amazon reveals significant hurdles remain for replicating the pricing and experience of an in-store shop for
everyday consumable products. Amazon was priced at roughly a 20% premium to Wal-Mart and this excludes
charges for Prime membership. In addition, it still appears early in development as many items require bulk
purchases to get good prices. For example, one box of Pop-Tarts was $7.85, well above Wal-Marts price of
$1.98. If we wanted a case (which included 12 items) from Amazon, the price drops to $1.88. Frozen and fresh
items are not currently practical to purchase in our (Connecticut) market. Our pricing survey data is available
upon request.
Wal-Marts own e-commerce efforts: Given the aforementioned research that consumers are pretty
interested in buying everyday products online, it seems smart at first blush for Wal-Mart to invest aggressively
in online capabilities. Upon further review, however, we believe Wal-Mart is potentially making a sizable
mistake. First, these investments take money away from the core U.S. business, money that can be used to
lower prices and invest in infrastructure, making it harder for Amazon to match Wal-Mart on prices over time.
Second, the online consumables model remains unproven economically, suggesting a go-slow approach is in
order. There is simply nothing wrong with observing Amazons activities, especially as the customer base is
somewhat different. Third, and most importantly, we view the companys efforts in e-commerce, particularly in
consumables, to be potentially cannibalistic to sales and detrimental to profits. If customers that would have
otherwise come into the stores now choose to shop online, flow to the store assets is reduced. Traffic is the
most important factor for Wal-Mart, as more traffic means more opportunities for upselling. A supercenter
works in large part because you drive a customer through the stores power alleys where smart merchants set
out displays with DVDs and other intriguing impulse purchase items. The more customers forgo stores to
shop online instead, the more Wal-Mart disenfranchises its own retail assets, in our opinion.
Exhibit 20: Walmart U.S. Comp Traffic
1.5%
1.0%
0.5%
-0.5%
-1.0%
-1.5%
-2.0%

Q1:13A Q2:13A Q3:13A Q4:13A Q1:14A Q2:14A Q3:14A

Walmart U.S. Customer Comp Traffic
Source: Company filings

Government/labor groups: As was discussed earlier in the report, there appears to be no end in sight for
Wal-Marts rising costs of doing business as represented by the FCPA actions, as well as the recent NLRB
complaint. Further, labor groups, especially the United Food and Commercial Workers International Union,
have been actively trying to unionize Wal-Mart and have engaged over the years in a broad campaign to point
out what they believe are poor wages and working conditions at the company through groups such as Wake
Up Walmart and Our Walmart. Whether these grievances have merit is somewhat beside the point for equity
investors, as this campaign against the company looks to continue/accelerate and has an administration in
Washington that is friendly to the cause. As such, expenses will likely increase as Wal-Mart is forced to defend
itself, leaving less money for price investments.
WolfeResearch.com

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Wal-Mart Stores Inc.

February 6, 2014

We See Few Easy Choices for the Company

The outlook over the next 1-3 years appears muted regardless of what path the company chooses, in
our opinion. Given the decline in Wal-Marts price advantage in the fast-turning/high-household penetration
items across grocery and consumables, our research would indicate that smaller price investments spread
over a longer time period are likely to have less of an impact and bear a greater risk of being competed away.
At the same time, it is unclear whether smaller investments would be enough to make up for what advantage
the company has lost over time. This would suggest to us a continuation of sluggish same-store sales and slow
earnings growth (this is what we are currently modeling). If Wal-Mart were to invest more heavily to reestablish historical price gaps, this would have negative implications for profitability and earnings (as we outline
on the next page). In our opinion, either way one looks at the options for the U.S. consumables business
1) continue down the same path and allow the competitive price advantage to narrow further, which we view as
detrimental to sales and profits long-term; 2) a larger price investment that may improve sales more quickly,
but has a greater impact on profitability; 3) smaller investment(s) that impact profitability less, but perhaps take
longer to generate a sustainable sales lift it appears that sales and earnings growth from the U.S. business
is likely to remain subdued in the near/medium term.
A large scale price investment appears less likely in the short-run, suggesting more of the same sales
challenges are on the horizon. With SG&A costs likely to remain elevated over the next few years and limited
catalysts to drive sales higher in the short-run, we view a low likelihood that Wal-Mart is able to generate
significant incremental capital to pre-fund larger price investments in its U.S. consumables business. While
Wal-Mart will remain focused on its productivity loop and driving costs out of the business, which it has done a
very good job (especially in the U.S.), the ability to shrink costs becomes increasingly difficult with sluggish
sales and higher e-commerce and compliance costs. At the same time, we view management as more likely to
protect profitability at the expense of sales, adding further credence to the idea that a near-term sizeable price
investment in the U.S. operations is low.
We believe $2.5 to $4 billion in price investments is needed in grocery and consumables to re-establish
a double digit price gap. In Exhibit 21 on the next page, we have outlined our quantification for the potential
price investment Wal-Mart would need to make in its grocery and consumables business in the U.S. in order to
re-establish its pricing advantage, according to our analysis. This analysis is focused specifically on the fastturning and high-household penetration items where Wal-Mart has seen its price advantage narrow, or what
we estimate to be roughly 25% of Wal-Marts consumables sales in the U.S. The 25% estimate gives credence
to the companys position, which is supported by our research, that it continues to enjoy significant price
leadership in items that turn less frequently. A conservative estimate suggests that a little over $2.5 billion is
needed to accomplish this goal, which amounts to roughly 90 bps in margin in the U.S. business, and over 50
bps to the consolidated P&L. We have used a conservative 67% weighting to estimate the percent of the U.S.
store base that may need to invest in its grocery/consumables business, as we believe there remain markets
such as Florida and California where price investments are not needed at this time. If more competitors move
to challenge Wal-Mart, the initial margin impact could be higher. So, we have also quantified what the impact
would be if 100% of the store base was in need of price investment, which equates to approx. 140 bps of U.S.
margin degradation or upwards of $4 billion.

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February 6, 2014
Exhibit 21: Estimated Price Investment Quantification for Walmart U.S Consumables Business ($mm)

Potential Price Investment Needed

Est. Low-End
Est. High-End
FY16E Walmart U.S. Net Sales (mm)
Times: Estimated % of Grocery and Consumables Net Sales
Walmart U.S. Grocery and Consumables Net Sales

$289,681
55.0%
$159,324

$289,681
55.0%
$159,324

Walmart U.S. Grocery and Consumables Net Sales

Times: Estimated % of U.S. Business Needing Price Investment
Applicable Net Sales Needing Price Investment

$159,324
66.7%
$106,216

$159,324
100.0%
$159,324

Applicable Net Sales Needing Price Investment

Times: Estimated % of Fast-Turning/High-Household Penetration Net Sales
Fast-Turning/High-Household Penetration Net Sales

$106,216
25.0%
$26,554

$159,324
25.0%
$39,831

$26,554
10.0%
$2,655

$39,831
10.0%
$3,983

0.9%

1.4%

Fast-Turning/High-Household Penetration Net Sales

Times: Estimated Price Investment Needed
Estimated Price Investment in the U.S.
Estimated Margin Impact for U.S. business
Source: Wolfe Research estimates

Translating the structural issues what a large scale price investment could mean to the P&L. While
we outline on the next page what we view as the most appropriate long-term course of action for the company
and its U.S. operations, in this paragraph we have also attempted to quantify what a large scale price
investment could mean for sales, profits and earnings. In the short-run, a price investment in the magnitude of
just over $2.5 billion would reduce FY16 EPS (first year of implementation for illustrative purposes) by upwards
of $0.50, according to our calculations, and lower EPS to $5.25 from our current FY16 EPS estimate of $5.78.
The benefit of the price investment would be a jump-start to sales, although there is typically some delay in
customer response and so we have modeled a greater benefit in years two and three than in year one. Under
this scenario, we forecast comp sales for Walmart U.S. of 0.5%, 3.0% and 2.5% in those first three years
following a large-scale investment in price. Perhaps what is most important for improving intrinsic value is the
long-term sales trajectory. Longer-term, we estimate comp sales grow in the low single-digit range (+2.5%).
This is well above the comp trajectory we see if the company were to continue down the current path and let
price gaps with competitors in consumables continue to shrink, something we estimate could lead to slightly
negative comps over time. From a margin perspective in WMTs U.S ops, $2.5 billion translates to roughly 90
bps in EBIT margin contraction in year one. However, given the more robust comp sales outlook anticipated
following the price investment, we forecast slight margin improvement as better sales, combined with a
reinvestment loop lead to slight SG&A leverage. Long-term, we arrive at an EBIT margin in the U.S. of 7.5%.
Short-term pain and long-term gain suggests higher intrinsic value for the equity long-term. Indeed, a
look at our discounted cash flow model under the above scenario of implementing a larger scale price
investment suggests much higher intrinsic value for Wal-Marts equity of approximately $110. This is well
above the DCF value of $81 associated with our current model, which largely reflects the status quo (i.e.
continuing down the same path and seeing the companys price advantage erode further in consumables in the
U.S., which we view as detrimental to comp sales and margin long-term). While we believe there is a sweet
spot in terms of the price investment strategy (as we outline on the next page), there nevertheless appears to
be merit over the long-term from a valuation perspective, in our opinion, of taking the steps to re-establish the
companys core, price advantage. Our margin investment model is available upon request.
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February 6, 2014

If We Could Be So Bold as to Make a Few Suggestions

Use a drone, not a B52 carpet bomber. We firmly believe that the company needs to go after market share
and re-establish its core competitive advantage of price, but this needs to start with easier targets. Wal-Mart
should pick battles in markets with competitors that will have a hard time matching lower prices over a long
period. Kroger and HEB are clearly not on this list. Price investments are almost always difficult, quickly
reducing current EBIT for gains down the road. By targeting this investment against weaker competitors, the
returns are likely to come much more quickly and be sustainable.
SWAT teams for underperforming stores. Management has acknowledged that about 10% of its U.S. stores
are seeing fairly negative sales trends. Rather than closing these assets (shrinking to profitability is pretty hard
in retail), management should first move to try and improve the stores execution. Many of these stores are
front and center with regards to the out-of-stock problems, and we believe some more labor would be helpful.
We envision roaming teams trained in store execution excellence that can be deployed when a store starts to
hit certain negative metrics. Lifting the underperformers is a relatively cost effective way to get sales going and,
while short-term costs will rise, returns should come relatively quickly.
Stop chasing the Amazon mirage. As we indicated earlier in the report, the economics of e-commerce in
consumables are unclear and history shows that being a follower with technology trends can actually be an
advantage. We would suggest slowing down the spending and reinvesting that money in lower prices and U.S.
infrastructure.
Replace the productivity loop mantra with a sales and productivity focus. It appears that the company
has perhaps overemphasized reducing expenses and this has eaten into sales growth. Increasing labor
productivity is good, but reducing labor expenses so much that out-of-stocks become a big issue is
problematic. While we are not privy to exact incentives for store level management, a balance between sales
and profits usually makes the most sense. It appears currently that incentives are too focused on costs given
the execution troubles observed at the stores, in our opinion.
One word of caution slowing CapEx and closing stores may not be the panacea and could result in
short-term gains, but further long-term pain. Indeed, we believe that there has been underinvestment in the
companys historical core competency of logistics and Wal-Mart needs to quickly reallocate capital to this area
of the organization. Our sources suggest that the company has fallen behind rivals such as Kroger in
distribution automation, for example. At the same time, closing stores can quickly lift short-term profits, but
tends to aggravate longer-term issues. A great demonstration of this idea would be lost volume discounts from
suppliers which would likely exacerbate the pricing issues resulting in more downward pressure on sales,
earnings and ROIC.

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Wal-Mart Stores Inc.

February 6, 2014

The U.S. Macro Climate Remains Challenging

Economic headwinds and government policy decisions also look to be pressuring Wal-Marts core U.S.
customer and business. In addition to the longer-term, structural concerns impacting the companys ability to
generate better sales in the U.S. that we have noted in the pages above, Wal-Marts core, low/middle income
customer remains under pressure. The cut to the food stamp program (SNAP) in November 2013 has already
begun to have an impact. When signed into law, the new farm bill would mean an additional roughly $8 billion
in cuts to the food stamp program over the next 10 years, which would be yet another hurdle for some of WalMarts customer base. At the same time, uncertainties around the Affordable Care Act, as well as our research,
including discussions with industry contacts, suggests that the implementation of the ACA could end up
reducing disposable income for some middle income Americans. In fact, as we highlighted in our Friday Retail
Recon note published on January 14th, one CEO we spoke with believed that middle-income families are
being particularly impacted by the changes in the healthcare landscape. For employees of this company, total
personnel compensation is up 8%, as the company moved to shoulder a greater portion of the mandated
costs. However, he acknowledged that take-home pay is likely down for most people at the company due to
very small raises, higher healthcare contributions and higher healthcare deductibles. He also believed that this
is an issue likely facing many companies and their employees.
Improving employment is a positive, but the environment remains tepid. Indeed, with supermarket comps
most highly correlated with the employment rate at around 0.70 (Wal-Marts U.S. business is roughly 0.58), the
improving labor market has certainly been helpful for retail sales. However, looking more closely, participation
rates have also fallen, suggesting that the normally positive impact to spending and comp sales is likely not as
robust as it would otherwise be with greater employment participation.
Inflation isnt lending a hand either. CPI food at home has hovered around 1% since the fall of calendar
2012 (latest reading of 0.6%). A little inflation (~2-3%) can provide a nice tailwind to sales and help lever
retailers fixed costs, however these low levels are clearly not providing such a tailwind and is making the
topline environment more difficult. This low-inflation environment is not anticipated to change drastically in the
near-term and while this is not likely a surprise to many, it is nevertheless one additional factor which could
conspire to keep a lid on sales in the coming quarters.

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February 6, 2014
Exhibit 22: U.S. Employment Data

67.0%

10.25%

66.5%

9.25%
66.0%

8.25%

65.5%

7.25%

65.0%

64.5%

6.25%

64.0%

5.25%
4.25%
Dec-07

63.5%

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

63.0%
Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Workforce Participation Rate

U.S. Unemployment Rate

Source: Bureau of Labor Statistics

Exhibit 23: CPI Food at Home

8.0%
6.0%
4.0%
2.0%

0.0%
-2.0%
-4.0%
Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13
CPI Food at Home
Source: Bureau of Labor Statistics

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February 6, 2014

International Doesnt Look Very Rosy

International remains a work in progress. A sustained improvement in the U.S. business should go a long
way in improving equity performance for Wal-Mart as this would carry more weight than a turnaround in the
International business, in our opinion. While some of the companys international markets are doing better than
others, the climate in the short-term looks to be characteristic of subdued sales. Couple this with continued
spending in ecommerce and compliance costs, despite managements focus on ratcheting down costs across
the business and we dont anticipate much upside from this side of the business any time soon.
Exhibit 24: GDP Growth in Countries Where Wal-Mart Operates
10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

-2.0%
Q4-2011
Argentina

Q1-2012
Brazil

Q2-2012
Chile

Q3-2012
China

Mexico

Q4-2012
South Africa

Q1-2013

Q2-2013

United Kindom

Q3-2013
Canada

Japan

Note: Growth rate is compared to the same quarter of the previous year, seasonally adjusted.
Source: Organisation for Economic Co-Operation and Development

Currency headwinds are likely to weigh on near-term results. While currency ebbs between a benefit and
a headwind given the many countries in which Wal-Mart operates, foreign currencies are currently a fairly
sizeable headwind for the company. While we tend to look through the currency to the F/X neutral
performance, this is simply another factor that looks to be negatively impacting sales and profitability in the
international segment currently.

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DISCLOSURE SECTION
Analyst Certification:
The analyst of Wolfe Research, LLC primarily responsible for this research report whose name appears first on the front page of this
research report hereby certifies that (i) the recommendations and opinions expressed in this research report accurately reflect the research
analysts personal views about the subject securities or issuers and (ii) no part of the research analysts compensation was, is or will be
directly or indirectly related to the specific recommendations or views contained in this report.
Important Disclosures:
Wolfe Research, LLC Fundamental Valuation Methodology:
Company:
Fundamental Valuation Methodology:
WMT
Forward P/E; Discounted Cash Flow Analysis
Wolfe Research, LLC Fundamental Target Price Risks:
Company:
Fundamental Target Price Risks:
WMT
A significant slowdown/curtailment of SG&A (e-commerce, regulatory/compliance costs)
allowing the company to re-establish U.S. pricing gaps in grocery/consumables without
material profitability impact; A strong balance sheet provides some flexibility for dividends
and share repurchases; WMT has historically been a safety trade, but this seems less
compelling, in our opinion; Valuation is not expensive
Wolfe Research, LLC Research Disclosures:
Company:
Research Disclosures:
WMT
None
Other Disclosures:
Wolfe Research, LLC Fundamental Stock Ratings Key:
Outperform (OP):

The security is projected to outperform analyst's industry coverage universe over the next
12 months.
The security is projected to perform approximately in line with analyst's industry coverage
universe over the next 12 months.
The security is projected to underperform analyst's industry coverage universe over the
next 12 months.

Peer Perform (PP):

Underperform (UP):

Wolfe Research, LLC uses a relative rating system using terms such as Outperform, Peer Perform and Underperform (see definitions
above). Please carefully read the definitions of all ratings used in Wolfe Research, LLC research. In addition, since Wolfe Research, LLC
research contains more complete information concerning the analysts views, please carefully read Wolfe Research, LLC research in its
entirety and not infer the contents from the ratings alone. In all cases, ratings (or research) should not be used or relied upon as investment
advice and any investment decisions should be based upon individual circumstances and other considerations.
Wolfe Research, LLC Sector Weighting System:
Market Overweight (MO):
Market Weight (MW):
Market Underweight (MU):

Expect the industry to outperform the primary market index for the region (S&P 500 in the
U.S.) by at least 10% over the next 12 months.
Expect the industry to perform approximately in line with the primary market index for the
region (S&P 500 in the U.S.) over the next 12 months.
Expect the industry to underperform the primary market index for the region (S&P 500 in
the U.S.) by at least 10% over the next 12 months.

Wolfe Research, LLC Distribution of Fundamental Stock Ratings (As of December 31, 2013):
Outperform:
Peer Perform:
Underperform:

44%
42%
14%

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0% Investment Banking Clients
0% Investment Banking Clients

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Wal-Mart Stores Inc.

February 6, 2014
Wolfe Research, LLC does not assign ratings of Buy, Hold or Sell to the stocks it covers. Outperform, Peer Perform and Underperform are
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