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Hard Yards Still Ahead For Woolworths

Australia | Oct 31 2016

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

Woolworths delivered improvement in supermarket sales in the September quarter but brokers believe the hard yards remain ahead of the business.

-Questions raised over the sustainability of revitalised sales and the competitive response
-Supermarket turnaround expected to take longer and cost more
-Is there room for both Big W and Target?

By Eva Brocklehurst

Woolworths ((WOW)) delivered an improvement in Australian supermarket sales in the September quarter, a commendable development brokers believe, as it provides some indication that the company's efforts to turn the business around are delivering results.

Yet Macquarie observes the industry is full of suggestions that the market is becoming aggressive, which raises a question regarding how much of a free kick Coles ((WES)) has received previously while Woolworths was working through its other problems. On the other hand, the broker notes this also raises a question about the sustainability of revitalised sales for Woolworths.

Like-for-like sales grew 0.7% in supermarkets, and Deutsche Bank estimates Woolworths may have had better growth on this front than Coles during the quarter. The broker suggests the building blocks are in place for gradual improvement over coming quarters but suspects the market may be too optimistic about FY17 margins.

While price investment and more effective use of loyalty points to drive increased share from existing customers has worked, Macquarie has doubts about the cost and what this strategy will induce from the competition. The broker believes the market is pricing in an aspirational recovery in Australian food retailing that is unlikely. While a stock undertaking a turnaround could be expected to trade ahead of fundamentals, the valuation process demonstrates how much is factored in at the current share price.

Morgan Stanley also suspects the market has prematurely priced in a turnaround and this turnaround is being hampered by the significant level of price and promotional investment required to drive top line growth. The broker notes items per basket remain weak, which implies customers are choosing to cherry pick specials. Until there is a clear path to over 2% like-for-like sales growth, with a sustainable level of investment, the broker believes a turnaround is some way off.

Morgan Stanley expects Aldi will continue to obtain a greater share of the consumer's wallet and this will put continued pressure items per basket. Moreover, as as investors increasingly focus on the first half results, the broker expects Woolworths shares to de-rate. Morgan Stanley forecasts a first half EBIT (earnings before interest and tax) margin for food at 4.28%.

UBS acknowledges that on face value, like-for-like sales in grocery have turned up, but retains a Sell rating on the basis that earnings risk still exists for FY17. The broker expects a competitive response from Coles and Aldi, with the risk that pricing intensity rises and a price war ensues. The broker continues to expect Woolworths will lose share in food & liquor as intensity steps up at Coles, share loss slows for the Metcash ((MTS)) IGA chain and double digit sales growth continues at Aldi.

UBS assesses the sustainable medium-term EBIT margin for Australian food & liquor is 5% or less and Australia remains one of the most profitable grocery markets globally. This signals there is downside risk to EBIT margins for Woolworths, given a need to re-invest to regain like-for-like momentum. Woolworths is a good company, in the broker's opinion, but it will take longer and cost more to turn around.

Outside of the supermarkets, Macquarie notes Big W is guiding to losses again in FY17 and concludes that there is a strong probability that there is only room for either Big W or Target plus Kmart in the discount department store segment. The latter two are owned by Wesfarmers. At best, the broker suggests both Big W and Target may take longer than expected to find a base.

Credit Suisse, too, believes the risks at Big W increase to the downside in FY17 because of the impact of changes to range and a deteriorating trading environment. Big W reported like-for-like sales declined 5.7% in the quarter. Credit Suisse forecasts Big W will return to profit in FY18 as its range stabilises and results in a reduction in the cost of goods.

UBS assesses the Australian department store EBIT pool has declined over the past five years, driven by Big W and Target, and the sector's performance is largely a matter of shifting between players, ie a fixed-sum game. While its estimates imply this profit pool will grow at around 12% over the next four years, UBS accepts this may prove optimistic. The main risk is heightened competitive activity from international players such as Uniqlo, H&M and Zara.

On FNArena's database there are three Hold and three Sell ratings. The consensus target is $22.16, suggesting 5.7% downside to the last share price. Targets range from $19.10 (UBS) to $24.79 (Morgans).

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