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Thoughts on Walmart & Our Trip to South Africa

October 2015

Portfolio Update

The brief slump in equity prices in August along with weaker emerging market currencies allowed us to add to our holdings in Arca Continental and Coca-Cola Embonor at prices we expect to yield a good return.  The window of attractive prices for these two companies was brief, and limited trading volume at our desired prices prevented us from buying as much of either as we would have preferred.  In general, the relatively quick recovery of U.S. stock prices returned the valuations of U.S.-based businesses that we like to prices well above ones at which we would add to what we already own or at which we would build a new position.

One exception is Walmart, which traded off sharply earlier this month after the company announced lower than expected net income guidance for next year during an analyst day that we attended.  Walmart is investing in two big initiatives.  The first is transforming the world’s most profitable bricks and mortar retailer into an integrated retailer that can seamlessly service customers in stores, online, and in a hybrid of the two.  This shift is well underway, but it is expensive.  Second, Walmart correctly perceives a need to improve its customers’ experience in its stores.  To begin to enhance the experience, Walmart is raising starting wages from below $8/hour to $10/hour to attract better front-line associates.  Seventy-five percent of the projected decline in earnings for next year is represented by this investment in labor.  Other efforts to better the customer experience include reinstituting department heads and improving the fresh grocery offering.

Once the in-store experience improves, Walmart plans to lower prices in 2017 (fiscal year 2018) to draw customers and to drive comparable store sales in fiscal years 2018 and 2019.  These investments in labor and lower prices will flow through the financials differently than if the company opened new stores (as an expense on the income statement rather than as capex on the cash flow statement), but they ultimately are not any different from an owner-earnings perspective provided that the investments are indeed wise.  We are closely monitoring the execution of these initiatives to assess whether they increase traffic, sales, and customer satisfaction.

In the case of Walmart, we would be much more concerned about the health of the company if the lower than expected guidance was due to top-line revenue concerns.  The reality is that Walmart is still a growing business, maintaining its moat of low-cost leadership.  To better satisfy the customer of tomorrow, Walmart is trying to both improve its in-store experience and create a compelling online offering.  We expect that the company will still make around $13 billion in owner-earnings next year after accounting for these new investments.  We believe the company’s share price has declined much more than its intrinsic value, increasing both our margin of safety in the investment and our expected future returns from it.

Research Trip

We have been interested in investment opportunities in Africa for several years.  While there are certainly many challenges, the potential to reach a large, young, and growing population should yield some attractive opportunities over time.  As a starting point for better understanding consumers in Africa, Richard spent ten days in South Africa meeting with the management teams of several interesting companies as well as visiting a variety of stores.  He returned very impressed with management at one company in particular, and we hope that we will get the chance to buy this business or one or two others that Richard visited when appropriate margins of safety are present.

Despite these interesting individual opportunities, our eyes are wide open to South Africa’s problems.  President Jacob Zuma’s administration and parts of his party, the African National Congress (ANC), have been systematically corrupt, including recent bribery scandals involving Hitachi and Volkswagen.  But encouragingly, discussions with people among all races and across the socioeconomic spectrum revealed widespread recognition of this corruption.  This recognition and the resulting popular outcry are unlikely to threaten the ANC’s control over the federal government, but hopefully it will lead to some positive change at the margin.  Archbishop Desmond Tutu has recently lent his gravitas to the opposition of this corruption, reminding people of the sacrifices of the anti-apartheid movement.  Security, pro-labor union policies, and brain drain remain big structural issues for South Africa to confront.

South AfricaNew construction in Johannesburg

South Africa 2Sasko is a popular consumer brand in South Africa

South Africa 3Typical informal supermarket; this one is located in Soweto.