Wal-Mart's Giant Challenges

Size could become a liability in a low-inflation environment.
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Updated from 8:40 a.m. EST

Wal-Mart's

(WMT) - Get Report

earnings prove once again that the retailer remains the leader in its segment. But analysts say there are plenty of reasons to remain cautious on the stock.

The world's No. 1 retailer posted a 23% increase in third-quarter earnings and said fourth-quarter results would be roughly in line with consensus estimates. But experts were quick to point out that the outlook for consumer spending is still murky, that deflationary forces threaten to undermine same-store sales over the long term and that the stock is already fully valued.

"Wal-Mart continues to be on a roll but even discounters cannot escape the pressures on consumers for caution in spending," noted retailing consultant Kurt Barnard.

Top and Bottom

Wal-Mart earned $1.82 billion, or 41 cents a share, in the quarter ended Oct. 31, up from $1.48 billion, or 33 cents a share, a year ago. Sales rose 11.5% to $58.8 billion on a 3.5% jump in same-store sales. Analysts had been expecting earnings of 40 cents a share, according to Thomson Financial/First Call.

The company said it expects to earn 53 cents to 55 cents a share in the fourth quarter and $1.76 to $1.78 a share for the fiscal year. Analysts on average had projected a 55-cent profit for the quarter and $1.78 for the full year.

During a recorded conference call, CEO Lee Scott said the retail environment remains "difficult" and noted that the "increase in spending is less than all of us would like." But he also said the firm is well positioned going into the crucial holiday shopping season.

Grinding Down

Wal-Mart has seen same-store sales slow down to a rate of 2% to 4% in recent months as consumers worried about rising unemployment, depressed stock prices and fears about war with Iraq. The firm managed to post solid results in October, however, thanks to a surprise cold snap, which spurred seasonal demand. It also expects same-store sales to climb 3% to 5% in the fourth quarter.

Richard Hastings, vice president, chief economist and retail analyst at Cyber Business Credit, said he expects Wal-Mart's same-store sales to remain below historical levels for a long time.

"The vast price differentials between stores don't exist anymore," he said. "Consumer goods are in a deflationary environment."

In the past, Wal-Mart was able to post same-store sales of between 6% to 8% as consumers flocked to the discounter in search of bargains. But Hastings said prices at department stores and other retailers are now much more competitive than they once were.

As such, Wal-Mart must improve both the quality and the value of its merchandise in order to lure shoppers and drive comparable sales at the pace it once did, he said.

"The days of people going to discount stores because they can't afford to go anywhere else are over," he said, adding that Wal-Mart must invest more money into its apparel product lines, hire more people and improve the shopping experience, particularly at its Sam's Club unit.

Wal-Mart announced recently that it would expand its George line and said it would sell discounted Levi Strauss jeans and clothing, which Hastings said is a good start.

Volume

Of course, other analysts point out that Wal-Mart's sheer scale will enable the firm to keep prices lower than many of its competitors in the future. The company is rapidly expanding internationally and is expected to produce earnings growth of 19% in fiscal 2003, according to Thomson Financial/First Call.

Over the last five years, Wal-Mart produced top- and bottom-line growth of 13% and 17.6%, respectively, and Bill Dreher, an analyst at WR Hambrecht, believes these rates should be maintained going forward as the firm continues to steal market share from almost every segment.

Still, Hastings said Wal-Mart's leadership position is already fully priced into the stock. Shares have moved sideways over the past year, while other discounters have declined. In addition, the stock trades at 31 times this year's earnings, well above its lifetime average of 24 times current year estimates.

"I think it will zigzag in a narrow range for a long time," Hastings said. "It won't go down much because it is a safe haven and a segment leader, but that doesn't mean it will go up. There's no specific enthusiasm about the stock."

Dreher, who has a hold rating on the stock and a price target of $49, agrees. "We expect Wal-Mart shares to be trading-range bound in the $45 to $55 range," he said, adding that promotions will eat into profit margins during the fourth quarter. "Wal-Mart is not immune to the macro forces of moderating consumer sentiment and more frugal consumer spending."

During the third quarter, the firm posted same-store sales of 4.2% at its Wal-Mart stores division and said Sam's Club comparable sales grew 0.4%. The international segment posted an operating profit of $447 million, up 42.4% from $314 million last year.

Shares rose $1.88, or 1%, to $54.86 in midday trade.