This week’s deliberate practice challenge from Whopper Investments was Wal-Mart (NYSE:WMT) in 1990. As Whopper explains, legendary investor Warren Buffett began buying shares of WMT sometime around 1990 with the intention of purchasing 100 million shares of the company. Buffett disclosed years later that he only bought 5 million shares because he was “sucking his thumb.” Buffett used this as an example of an error of omission. Everyone is familiar with errors of commission, when we do something and things go wrong. By highlighting this example, he was reminding himself and his shareholders that not doing something, an error of omission, can be just as costly as committing an error. Buffett estimates that not buying those other 95 million shares cost Berkshire Hathaway (NYSE:BRK.A) $8 to $10 billion. The challenge was to analyze and value WMT at the end of 1990 using the company’s 1990 annual report.
It was fascinating to go back 22 years and read WMT’s annual report. WMT was not the ubiquitous company that it is today. While the company’s associates were recognized as the 1989 Mass Market Retailers of the Year by Mass Market Retailers trade publication, the company only had stores in 29 states, no stores in large states like California and New York and no international presence. With 275,000 employees and 27 consecutive years of sales and earnings records, the company wasn’t unknown to be sure. One has to imagine that the company’s growth story was well known on Wall Street but at the same time, it is hard to imagine the late 1980s master of the universe trader getting excited about a discount retailer with headquarters in Arkansas that locates their stores in mostly rural locations.
What did Warren Buffett see in WMT in 1990?
Warren Buffet on the other hand, would be astute enough to get excited about an Arkansas based company with mostly rural locations. At the first glance of the 10-year financial summary, the consistent growth of the company jumps out. Year-over-year revenue growth from 1982 through 1990 was 49%, 38%, 38%, 37%, 32%, 41%, 34%, 29% and 25% and year-over-year earnings per share (EPS) growth was 46%, 44%, 52%, 37%, 21%, 36%, 41%, 33% and 28%. This is a hell of a growth company! Warren Buffett was buying it?
The first thing that stands out to me is that the growth was trailing off year-over-year in the last two years in the series. Did the market think the growth story was broken? Did the market sell the shares off in the shadow of Operation Desert Storm and the first invasion of Iraq?
Using from Robert Hagstrom’s The Warren Buffett Way as a guide, WMT meets many of the tenets that he says Buffett looks for in a business.
Simple and Understandable
WMT buys products in quantity and then distributes and sells them for more than they bought them for. Pretty simple concept. This is difficult to implement but if you get really good at operational execution, you can stay ahead of the competition.
Favorable Long-Term Prospects
My favorite graphic other than the dollar signs found throughout the annual report is the background graphic for some the charts that shows a bag of items from WMT with the tag line, Always The Low Price On The Brands You Trust. There is the recognizable Tide box with a Polaroid box in front of it. I love seeing that Polaroid box, a company that was a member of the Nifty-Fifty in the early 1970s. Will it matter to WMT that there will be dramatic technological changes in the next 20 years that will make the instant photos offered by a Polaroid camera obsolete? No. Instead, WMT will just sell one of the devices that replaced the need for Polaroid film: the Apple iPhone. It is easy to see what WMT will look like in 10 to 20 years. They will be selling brands consumers trust at low prices.
Return on Equity
The chart also shows WMT’s return on equity averaging above 30% in the previous five years. We know that Buffett looks to return on equity as a valuable metric since he says in his 1979 Chairman’s Letter,
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Clearly, in the past, WMT has been providing excellent returns on equity. These high returns will attract competition. At the stage of growth that WMT was in at 1990, it is difficult to say they are ahead of the competition and have a strong moat to protect themselves from competitors. Instead, WMT was on the offensive while their competitors were most likely being complacent. Sears and K-Mart were old and napping while WMT was building their moat, a large distribution network with disciplined purchasing.
Buffett looks towards pricing power to identify franchises as he stated in his 1981 Chairman’s Letter,
Such favored business must have two characteristics: (1) An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment in capital.
Buffett’s partner Charlie Munger often quotes the algebraist Carl Jacobi, “Invert, always invert.” Where WMT might lack in pricing power, they make up in purchasing power. WMT is building up their presence as the large customer that their vendors have to answer to for survival. WMT is not beholden to any one vendor but some of their vendors are beholden to them. This build out puts them in the position as the low cost provider. Volume begets volume. I think Buffett saw an inflection point in WMT’s growth. WMT was beginning to get loolapoolza results in their operations. They were going to be able to maintain their returns on equity and strengthen their moat through additional investments in new stores and updating existing stores. Building this moat is likely to allow WMT to continue to achieve high returns on equity in the future.
The starting point for valuation is to calculate what Warren Buffett calls owner’s earnings. He defines owner’s earnings in the 1986 Chairman’s Letter,
Owner’s earnings …represents (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).
I “cheated” a little by pulling five more years of previous WMT annual reports so I could properly calculate owner’s earnings.
While five years does not make a trend, an interesting characteristic of the above table is that owner’s earnings appears to be turning positive. It is as if WMT’s past investments are now starting to pay off.
The next step is to estimate future owner’s earnings and find today’s value. Buffett explains in his 1992 Chairman’s Letter that,
The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.
Through all of my studies of Warren Buffett, I have yet to come across any information where he explicitly states how he values a company. While we know that Buffett uses a long time horizon, we don’t know the exact time horizon that he uses when estimating the value of a company. For the discount rate, we know he references the yield on the 30-year Treasury but there are some conflicting statements regarding how precise he references the yield. It is clear to me that he is using judgment to determine the discount rate that he uses. We also know that he has discounted… well… discounted cash flow valuations. While I am inclined to think that Buffett may use a terminal multiple on his owner’s earnings calculations and do the math in his head, I am going to proceed and refer to the method used by Hagstrom in The Warren Buffett Way due to the lack of any evidence that Buffett does it differently. I am doing this in the spirit of Whopper’s deliberate practice challenge. I am deliberating learning more about discounted cash flow valuation methods while at the same time trying to see what Buffett saw in WMT stock with the limited information available to me.
Similar to the Bill Ackman McDonald’s (NYSE: MCD) deliberate practice challenge where I did a near-term and a mid-term valuation, for WMT I am going to do a mid-term and a long-term valuation. I think this shows an interesting difference between Ackman and Buffett. Buffett is famous for his long-term view and holding of positions. On the other hand, Ackman implemented his MCD position with options so a shorter time horizon makes sense for his investment style.
In The Warren Buffett Way, Hagstrom uses what is basically a two-stage discounted cash flow model to value the equity of a company. Instead of discounted traditional cash flow metrics, he uses owner’s earnings.
I found forecasting 10 years out a little daunting at first. Hindsight basis possibly comes into play because I already know that not only does WMT survive over the next 20 years but it also prospers. I tried to keep my head back in 1990. To project revenue, I estimated that WMT would open 150 Wal-Mart stores and 25 Sam’s Club stores each year over the next 10 years. This was on the low end of the 165 to 175 Wal-Mart stores and 25 to 30 Sam’s clubs that management was targeting for 1991. So by the end of 2000, WMT would have 3,125 total stores. I assumed that depreciation continued at 1.0% of Net Sales which is the same rate it was in the previous five years. Based on previous capital expenditures (capex) levels, the approximate cost of building a store was around $6 million. I started with the cost at $6 million and assumed 3% per year in construction inflation so that per store costs were running around $7.8 million by 2000 and resulting in capex of $1.1 billion.
I didn’t see any reason for cost contraction in the annual report. With hindsight, I know that WMT was about to enter into a period where businesses saw unprecedented productivity improvement through the implementation of information technology (IT) spurred by the boom of the personal computer, networking and the Internet. I know that WMT has fabulously levered their IT capabilities over the years but I didn’t build that into my projections. I assumed cost of sales would remain above 77% and Sales, General & Administrative (SG&A) would remain above 16% over the time horizon both of which are on the higher end for WMT in the previous 10 years.
The 30-year Treasury was trading with an 8.25% yield at the end of 1990. Hagstrom uses 9% discount rate, which is what I am going to use.
The long-term valuation yields an intrinsic value estimate of $55.20.
The present value of the 10-year owner’s earnings is the sum of 10 years of discounted earnings found in the Owner’s Earnings table from 1991 through 2000. At year 10, I assume growth slows to 3% annually to value the second stage of the growth. The capitalization rate of 6% is derived by subtracting the 3% perpetual growth rate from the 9% discount rate, a standard method of discounting earnings into perpetuity. Capitalizing the year 11 owner’s earnings of $3.0 billion by 6% yields a $50.9 billion value at year 10. This needs to be discounted back to the present and that can be achieved by multiplying $50.9 billion by the discount factor of 0.4224. Adding the present value of $9.7 billion to the present value of $21.5 billion produces an equity value of WMT in 1990 of $31.3 billion. With 566.1 million shares outstanding, the intrinsic value per share comes to $55.20.
I have always felt uncomfortable with discounted cash flow valuations that are derived when a long time horizon like 10 years is used. The valuations always feel high to me when a company has high growth. To balance the long-term valuation, I also calculated the intrinsic value using all of the same assumptions but using a 5-year time horizon.
This results in an intrinsic value estimate of $26.30. So the mid-term valuation is $26.30 and the long-term valuation is $55.20. That is a pretty wide range. Obviously, there is some long-term upside if WMT is able to continue its strong growth beyond five years. However, I’m a little uncomfortable assuming WMT can grow that fast. It looks like Buffett was seeing a potential Growth At A Reasonable Price (GARP) investment in WMT.
I can see why he was caught sucking his thumb. Assuming that much growth in a valuation probably made him nervous about the price he paid. I would go with the $26.30 valuation and require a 20% discount to intrinsic value on the stock. So I would probably be sucking my thumb with a $21-1/8 buy limit order on WMT back in 1990.