Walmart's Payout Remains Safe Despite Worsening Retail Environment

Shares of Walmart on Tuesday fell more than 11% after a rare earnings miss was reported along with concerns about a deteriorating retail environment, marking the company's largest single-day loss since the infamous Black Monday in 1987. The discount store operator heads into the weekend having lost around 20% of its market value in just four days.

Operating income contracted by 23% last quarter despite sales growing a modest 2%, reflecting unexpectedly high costs that pressured the company's profit margins.

Walmart is not alone in reporting sudden margin declines. Many other retailers have revealed similar concerns, leading to the worst week for retailers since the early days of the pandemic.

Several factors have converged to compress retailers' profitability, including a swift inflation-inspired pullback in consumer spending on discretionary items, a spike in transportation and freight costs, and supply chain issues that have created a supply and demand imbalance.

Consumers have reduced their purchases of "bulky" discretionary items like TVs, patio furniture, and kitchen appliances as sales prices have reached levels customers aren't willing to pay as the rising costs of necessities like food and gas have squeezed wallets. 

Customers' pushback on prices is a bigger concern when considering Walmart's transportation costs were $160 million higher than expected in the U.S. alone last quarter. For perspective, annualizing those unexpected increased transportation costs amounts to around 5% of last year's earnings.

The rapid change in shopper spending habits suggests many consumers won't accept higher prices for discretionary items. And with soaring transportation costs not expected to abate any time soon, Walmart and other notable retailers will likely need to endure at least several more quarters of reduced profitability.

Further complicating the outlook for profits is the significant buildup in inventories. Many retailers like Walmart have aggressively built higher inventory levels to avoid the empty shelves of 2020 that led customers to search elsewhere for products. 

Increased inventories and stocked shelves helped induce higher foot traffic in stores, but the sudden drop in spending has left Walmart with an inventory over 30% higher than last year. These goods may need to be sold at discounted prices to clear up storage space for next season's products.

As the economy potentially teeters on the brink of a recession, it's hard to see these challenges quickly overcome. Inflation, the economy's most ominous threat, will likely take some time to work through.

While there will likely be at least a few rough quarters ahead for retailers, Walmart's lowered guidance predicts just a 1% drop in earnings this year which keeps overall income higher than pre-pandemic levels.

Walmart's drastic sell-off this week seems to be much less reflective of a dire long-term outlook for the company, and more likely just the market revaluing the company for a period of slower growth following two years of abnormal pandemic-boosted demand.

As you can see, Walmart's dividend yield and forward P/E ratio soared to relatively extreme levels in 2020-21 but have now reverted closer to their 5-year averages, making the stock look much more reasonably valued going forward.

Economic factors aside, Walmart is a well-run company with an AA rated balance sheet, provides a strong value proposition for pinched consumers, and has a stable customer base.

Furthermore, even as consumers reduce spending on discretionary items, the company sells an array of staples from groceries and diapers to medicines, which will keep customers shopping online and in stores.

Although Walmart's stock price may take several years to recover from recent losses, the firm's dividend should remain well-covered by profits.

Even after analysts slashed their earnings estimates in response to Walmart's latest results, the retailer's projected payout ratio stands near 35%, providing a healthy margin of safety and sitting below the company's historical norm near 40%.

As a result, we expect Walmart to continue its march towards Dividend King status by declaring its 49th consecutive annual dividend increase next spring. However, the increase will likely be a low-single-digit raise similar to the company's recent payout changes. 

Overall, Walmart is well-positioned to ride out a period of economic instability with an uninterrupted dividend. As such, we are reaffirming Walmart's Very Safe Dividend Safety Score.

As the economic backdrop remains unstable, we will continue to monitor the situation and provide updates if any development shakes our long-term outlook for the company.