Fitch Affirms Walmart at 'AA'; Outlook Stable
KEY RATING DRIVERS
Significant Scale, Defensible Market Position:
Walmart's ratings reflect the operational and financial flexibility and strong free cash flow profile that results from its substantial scale ($482 billion in 2015 sales) and dominant market position in North America. Despite its large size and increased competition from alternative discount formats, including online-only players, the company's ability to invest in its business while exercising price leadership has led to Walmart maintaining market share in nearly all categories in recent years.
The ratings consider Walmart's current investments in wages, e-commerce, and other initiatives, which have resulted in near-term EBITDA margin contraction. Despite the pressure on operating results, Fitch believes the company is making appropriate decisions to drive long-term sales growth while using its significant power vis a vis suppliers and other counterparties to support near-term cash flow with working capital improvements.
Positive U. S. Comps, Mixed Global Trends:
Walmart U. S., which represented 62% of revenue and 73% of operating profit in 2015, has reported eight consecutive quarters of positive comps, driven by seven straight quarters of traffic growth. Growth is being supported by investments in price and improved in-store execution and has been fairly broad-based across categories although grocery has exhibited volatility due to food deflation, which has had a 50 - 100 basis point (bp) impact in recent quarters.
Fitch expects U. S comps of 1% - 2% in 2016 and 2017 as positive store traffic and a modest but increasing contribution from e-commerce offsets the impact of deflation and price investments. Comp growth above 2% is not viewed as likely, given Walmart's size and that Walmart's U. S. comp growth has averaged about 1% since 2008.
Walmart International, which represented 26% of revenue and 20% of operating profit in 2015, has reported mixed comps across its key markets. Mexico is the segment's best-performing market, as comps rose 7.3% in the latest quarter. Conversely, the UK is the worst-performing, as comps declined 7.5% in the latest quarter, despite price investments. Fitch expects challenges in the UK may persist into 2017 due to heightened competition and a forecasted slowdown in GDP growth in 2017, but potentially a more robust economy in Mexico next year should support continued strong results in that region.
Sam's Club, which represented 12% of revenue and 7% of operating profit in 2015, has made a flat to negative contribution to Walmart's revenue since 2014 due to lower fuel sales. Excluding fuel, comps at Sam's Club have been consistently positive, despite slightly lower traffic, while membership income is growing at a low-single-digit rate.
Integrating Physical and Digital to Drive Revenue:
Walmart is improving the in-store experience while deepening its digital relationship with customers in light of the increasingly competitive landscape and shifting consumer buying habits. Cleaner and more organized stores, better customer service, and a focus on fresh food offerings are examples of ways Walmart is improving the in-store experience. Meanwhile, increased on-line offerings, new distribution centers, and a $49/year unlimited 2-day shipping pass are examples of how the company is strengthening its competiveness in e-commerce.
Fitch expects the pending acquisition of Jet. com to equip Walmart with enhanced technology and increased expertise to further strengthen Walmart. com and to expand Walmart's appeal to younger and urban consumers. Sales from physical stores will continue to represent the bulk of Walmart's revenue and the contribution from e-commerce is expected to increase only modestly, given Fitch's view that consumer shift towards on-line grocery will be more gradual than that of other categories.
Margins Reset, Stabilization Anticipated:
Fitch views the recent step-down in margins and EBITDA as a reset in Walmart's profitability but is balancing that against the company's improved cash flow generation. Walmart's operating margin declined from 5.6% in 2014 to 5.2% in 2015, due mainly to the impact of increased wages, benefits, and training for U. S. employees. Fitch expects Walmart's operating margin to decline another 50bps to 4.7% in 2016 due to the second leg of these investments. As a result, EBITDA could decline from a peak of $36 billion in 2014 to the $33 billion range in 2016 - 2017 before resuming modest growth in 2018.
Operating margin is expected to stabilize in the mid-to-high 4% range, absent additional large increases in wages. Over time, we expect gross margin to decline modestly as Walmart invests in price, offset by leverage on SG&A expenses.
Strong Cash Flow, Stable Leverage:
Walmart's considerable cash from operations (CFO), which has averaged over $26 billion annually since 2012, provides the company the financial flexibility to invest in its business and return cash to shareholders while maintaining relatively stable leverage.
Fitch anticipates that free cash flow (FCF; after dividends) will approximate $7 billion annually in 2016 and 2017, excluding any benefit from working capital improvement. This is despite a projected 7% decline in operating income in 2016 and flat operating income in 2017. Improvements in working capital could add another $1.5 billion to $2 billion to FCF in 2016 and 2017.
Fitch expects adjusted leverage (debt plus capitalized leases/EBITDAR) to remain stable at around 2x, as the current pace of share repurchases and investments such as Jet. com can be largely funded with internally generated cash.
Fitch's key assumptions within the rating case for Walmart include:
--Revenue growth of about 1% in 2016, and low to mid 2% range in 2017/2018, reflecting gradually improving comps and about 1% square footage growth beyond 2016;
-- Operating income declines 7% in 2016, is flat in 2017, and grows 3% in 2018;
--Operating margin approximates 4.7% in 2016 and stabilizes in the mid-4x range thereafter;
--EBITDA margin approximates 6.8% in 2016 and stabilizes near this range thereafter;
--FCF after dividends of approximately $7 billion annually in 2016 and 2017, excluding working capital benefit, and reflecting stable capex of roughly $11 billion and a projected 2% increase in dividends/share. FCF could be $1.5 -$2 billion higher on working capital improvements;
--Adjusted leverage of approximately 2x through the forecast period.
Positive Rating Action: An upgrade is unlikely, given the rating is currently at the high end of the rating spectrum and fully captures the company's financial and qualitative strengths.
Negative Rating Action: Future developments that may, individually or collectively, lead to negative rating action include a weakening comp trajectory, due to negative store traffic and in the absence of an acceleration in e-commerce contribution. Adjusted leverage sustained above 2x as a result of meaningful margin contraction beyond 2016, led by investments in business that do not result in top line growth or due to debt-financed share buybacks would also be rating concerns.
Walmart had nearly $18 billion of liquidity inclusive of revolver availability and readily available cash which excludes $700 million of oversees cash that may not be easily transferable, as of July 31, 2016. Liquidity is supported by the firm's meaningful FCF and good access to both bank and capital markets. Readily available cash is defined as reported cash, which totaled $7.7 billion at July 31, 2016, less $0.7 billion of cash that may not be fully transferable to the U. S. and operational cash of $650 million. Walmart has an undrawn $7.5 billion 364-day revolver expiring in June 2017 and an undrawn $5 billion revolver expiring in June 2021, which back up its $20 billion commercial paper (CP) program.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following:
Wal-mart Stores, Inc.
--Long-Term Issuer Default Rating (IDR) at 'AA';
--Senior unsecured debt at 'AA';
--Bank credit facility at 'AA';
--Short-Term IDR at 'F1+';
--Commercial paper at 'F1+'.
The Rating Outlook is Stable.