Wal-Mart’s (NYSE:WMT) Acquisition of South Africa’s Massmart – Huge Risk? Or Huge Opportunity?

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Wal-Mart (NYSE:WMT) announced on Monday that it intends to acquire South African retailer Massmart Holdings (MSM) for 32 billion rand ($4.6 billion). The U.S. retail behemoth has been battling weaknesses in the domestic market where its core low-income customers have remained financially strained due to the stubbornly high unemployment, and some of the affluent shoppers it gained during the recession have traded back up to higher-end stores. Wal-Mart stores in the U.S. have posted five consecutive quarters of same-store sales decline, and the company is looking to its international division to drive further growth. In fact, its international business reported a 7.3% increase in sales and a 12.7% increase in operating income, excluding currency impact, during the second quarter. In contrast, its U.S. business remained flat and operating income fell by 0.2% over the same period.

Although the Massmart deal is small relative to Wal-Mart’s size, representing just over 2% of Wal-Mart’s market cap, it presents significant growth opportunities for Wal-Mart. Acquiring Massmart, the 3rd largest retailer in South Africa, will give Wal-Mart a strong foothold to expand in South Africa and potentially into the broader part of the continent. Africa’s fast-growing markets where GDP growth rates are more than twice that of developed economies are an increasingly attractive target for foreign investors. However, the economy is plagued by high crime rates, political instability, a heavily unionized work force and high unemployment rate.

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While sales and earnings growth is nice, it does not always promise shareholder value creation. Wal-Mart said it would pay 148 rands per share for Massmart, which would represent a premium of about 10% over Thursday’s close of 134.75 rand. To dig into what Wal-Mart’s offer means and better understand the embedded expectations of the share price, we will utilize AFG’s Value Expectations™ framework.

The 3 charts below highlight MSM’s value drivers: Sales Growth, EBITDA Margin, and Asset Turnover. In order to frame whether the transaction makes sense or not, we will back into an answer that describes the sales growth Wal-Mart must achieve from Massmart in order to make this deal work out for existing WMT shareholders. We will first begin by determining a reasonable estimate of MSM’s sustainable EBITDA margin and then estimate how much capital MSM needs to sustain its sales level. Lastly we will compute the sales growth required to justify the 148 rands a share price Wal-Mart has agreed to pay.

Looking at the historical EBITDA margins in the chart below, MSM has consistently improved its EBITDA margins from 2.0% in 2000 to 5.3% in 2009, peaking at 5.5% in 2008. For our analysis, we will assume the 3-year median of 5.3% to represent MSM’s normalized long-term EBITDA margin. Given Wal-Mart’s purchasing scale and reputation for operating efficiency, 5.3% may be a conservative assumption. Next, we assume a 3-year median Asset Turnover ratio of 3.52 for MSM, implying that MSM must invest a dollar in assets to generate every $3.52 of sales. This is a reasonable assumption given that MSM has seen consistent improvement in its asset efficiency ratio, from 3.31 in 2006 to 3.62 in 2009.

Solving for sales growth, MSM needs to grow its top line by 20.8% each year over the next 5 years to justify the 148 rands share price. Although MSM’s sales growth averages 15.5% over the last ten years, the embedded expectations are rather high. To date, Wal-Mart has not released much detail on the proposed acquisitions, or provided any targets for revenue and cost savings, but we believe Massmart may benefit from Wal-Mart’s global supply chain and large buying power. In addition, Massmart’s low margin structure relative to Wal-Mart leaves a lot of room for margin expansion. In the last five years, Massmart’s EBITDA margin averages 4.9%, versus Wal-Mart’s 6.5%. Bottom line, to justify the share price offered to Massmart, Wal-Mart has to leverage its retail and operational know-how, and grow its top-line at 20.8% for the next five years.

Source: EconomicMargin.com

What Is The Value Expectations Interface?

AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedoes such as Cisco, whose expectations were unrealistically high.

After determining if a company is a valid investment opportunity, users have the flexibility to adjust expectations based on their own research, build out pro-forma financial scenarios, and arrive at an NPV target price.

In addition, the VE interface has all the key theoretically components of a well-thought-out valuation model, which takes into consideration the appropriate risk, with a market derived discount rate (MDDR) that is adjusted for size and leverage. Competition and perpetuity issues are also taken into account, using company specific Competitive Advantage Periods (CAP).

By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

Value Expectations Interface allows investors to:

• Understand the performance expectations embedded into today’s stock prices.

• Build out Different Pro forma Financial Scenarios

• Determine NPV target price based on the users assumptions.

• Quickly determine if a company is over/under valued

• Benchmark valuation attractiveness against peer groups

• Efficiently Identify investment opportunities or potential torpedo’s

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