Will Wal-Mart's woes rattle its stock?

By Michael Brush

Sure, social activists and labor unions have problems with Wal-Mart. But Norway?

Wal-Mart Stores (WMT, news, msgs) took another public relations hit last week when that country's government pension fund -- with more than $240 billion in assets -- banned the retailer's stock from its portfolio, citing "serious" violations of human rights and poor labor practices.

Now, Norway isn't just picking on Wal-Mart. The fund's ethics guidelines exclude investments in companies involved in human rights violations such as "murder, torture, deprivation of liberty, forced labor, the worst forms of child labor and other forms of child exploitation."

But the fund's action raises a question: Is the Wal-Mart portfolio poison? Will it turn into a name shunned by fund managers concerned about political correctness and potential legal liabilities stemming from lawsuits about labor practices?

Or is this a sign that less socially minded investors should be adding Wal-Mart to their own portfolios?

A shared concern?

First, let's get the he-said, she-said out of the way.

The Norwegian pension fund's concerns stemmed from charges that Wal-Mart pressures its employees to work overtime without compensation, locks workers in stores, employs minors in dangerous conditions and discriminates against women.

Wal-Mart spokeswoman Gail Lavielle responds "the characterizations that we have seen in the public statements don't appear to be based on fact."

Next, an important question: Are other big investors bailing along with the Norse?

The California Public Employees' Retirement System (CalPERS) typically plays an activist role at companies and has banned stocks to dodge potential legal liabilities. But it has no problem with Wal-Mart. "The only stocks we've ever divested of were tobacco stocks, and that was because of liability issues," says CalPERS spokesman Brad Pacheco. CalPERS was concerned tobacco lawsuit settlements could create losses, but it doesn't see this problem with Wal-Mart.

George Schwartz, manager of the Ave Maria Catholic Values Fund (AVEMX, news, msgs), finds it ironic that everybody hates Wal-Mart except "the millions Americans who shop there every week." Schwartz has no problems with Wal-Mart's labor practices. "To my knowledge Wal-Mart management has never held a gun to people's heads and forced them to work there," he says.

But his fund doesn't hold the stock because Wal-Mart pharmacies sell medications that can be used to prevent or terminate pregnancies.

George Rue, chief investment officer of the Presbyterian Church (USA) Foundation and the New Covenant Trust Co., holds the same view. Although his funds won't own shares in companies making money from alcohol, tobacco, gaming or firearms because of concerns about morality, he doesn't have a problem with Wal-Mart.

"As many people as they employ and as many countries as they are involved in, there are going to be issues. No company can be 100% perfect," says Rue. But Rue says he'd rather own shares so he can have a voice in Wal-Mart policies. (A member of the family of Wal-Mart founder Sam Walton is on the board of the Presbyterian Foundation.)

That's a view shared by some of the strongest Wal-Mart critics, including labor unions and activist groups. "The answer isn't to sell the stock," says Daniel Pedrotty of the AFL-CIO Office of Investment. "We take more of a long-term view that there is a lot better potential for getting the kind of reforms we want as owners."

Wal-Mart Watch, a coalition of groups including labor unions and environmental advocates that want to pressure Wal-Mart to improve its business practices, also does not advocate investors banning the retailer's shares from portfolios.

Money managers who own Wal-Mart shares weren't troubled by Norway's decision. "I didn't lose a whole lot of sleep over it," says Michael Morcos, a portfolio manager at Old Second Wealth Management, which has $1.3 billion in assets.

"Their labor practices are widely known. Most of the bad press is widely recognized and priced into the stock," says Morcos. He doesn't think the ongoing public relations issues will hurt sales much, either. "People may speak poorly about Wal-Mart, but they still go there to shop because price drives their purchasing decisions, and Wal-Mart has good prices."

Strong growth, low price

In addition to bad publicity, Wal-Mart stock has been dogged by concerns that customers will cut back on spending because of high gasoline prices, a slowdown in mortgage refinancing and possible economic weakness, which could reduce job growth.

Because of concerns like these, at $47, Wal-Mart trades for a price-earnings ratio of 14, in line with that of the S&P 500 ($INX), even though Wal-Mart's growth rate is about double the average company in that index.

Morcos, at Old Second Wealth Management, thinks the stock deserves a P/E of at least 17.5 because Wal-Mart has a solid franchise, solid financial strength and good growth prospects. That suggests the stock could move up to $59 next year, or 17.5 times projected 2007 earnings per share of $3.32.

Where is the growth coming from? Analysts say the following trends will support solid sales growth and better profit margins.

• Expansion plans. As much as Wal-Mart critics hate it, Wal-Mart still has plenty of room to grow, even though it is the biggest retailer in the country and has more than 6,150 stores globally. Wal-Mart's "super centers" -- large stores selling groceries, household items, appliances and clothing -- are concentrated in suburbs and rural areas of the South and Midwest. That leaves a lot of room for growth in the Northeast, California and major cities, says Morningstar analyst Joseph Beaulieu. Wal-Mart plans to add up to 600 new stores this year in the U.S. and abroad, or an additional 8% in square footage. It has about 1,400 stores in the pipeline overall. "Wal-Mart's long-term goal is to achieve a 25% share of the total U.S. retail market," says Lehman Brothers analyst Robert Drbul.

• Going upscale. Wal-Mart has a reputation for selling basics at bargain prices to consumers on limited budgets. But a lot of upscale shoppers actually visit super centers for the deals on staples and groceries. Wal-Mart wants them to "step across the aisle" and buy other merchandise, says Goldman Sachs analyst Adrianne Shapira. At a test store in Plano, Texas, Wal-Mart offers 1,500 different types of wine with prices up to $500 per bottle, a bigger selection of organic food, a sushi bar, more expensive appliances and a bigger selection of more stylish apparel. And Wal-Mart is expanding the availability of such items -- which produce higher profit margins. Wal-Mart is also remodeling 1,800 stores to make them more appealing to upscale shoppers.

• Supply-chain improvements. Wal-Mart also hopes to boost margins by improving inventory management and outsourcing more procurement to countries with low-cost labor, like China.

That may not please critics who bemoan the loss of U.S.-based manufacturing jobs, but it should be good for shareholders.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column. Brush is an award-winning New York-based financial writer who has covered business and investing for the New York Times, Money magazine and the Economist Group. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of "Lessons From the Front Line," a book offering insights on investing and the markets based on the experiences of professional money managers.