Uncertainty Hovers Over Woolworths

Australia | May 29 2019

As long as inflation is building in the food sector, Woolworths is considered a worthwhile holding but several brokers question whether this will last.

-Significant profit growth not expected amid surging cost pressures
-Woolworths at the forefront of grocery sector in terms of digital strategy
-New competition entering the market in 2021 likely headwind to sales growth


By Eva Brocklehurst

Several brokers downgraded Woolworths ((WOW)) in May, believing the stock is overbought and the outlook is going to toughen. The grocery market may be rational and food inflation has reappeared, but will it last?

The share price has risen 11.5% in the past month and is now well above Ord Minnett's valuation. The price/earnings (PE) multiple is high, at 20.6x FY19 estimates and 24.9x FY20 estimates, for 6.3% and 7.0% growth in earnings per share respectively. The broker notes the PE multiple has not been this high since late 2007.

The company's off-market buyback has been supportive yet the broker expects some weakness as it completes and investors reassess their investment.

Ord Minnett has downgraded to Lighten because of the removal of valuation support after the share price rally. Earnings (EBIT) margins are expected to decline in Australian food in FY20 because of higher labour costs. The broker cites significant cost pressures in the food division, not just labour but the petrol discount, rising depreciation & amortisation charges and dual distribution centre costs.

The mitigation of supplier cost increases has become an increasing focus for the company and this has driven some suppliers to withhold stock. Also, a turnaround in liquor is proving difficult, while earnings losses at Big W continue.

The company performed strongly in the March quarter, with 4.2% like-for-like sales growth in its core Australian food business. Sales at Big W rose 5.6%, which brokers note is the best performance in over 10 years. Nevertheless, several do not believe the quarterly outcome will provide substantial profit growth amid surging cost pressures.

As long as inflation is building, Deutsche Bank considers, while not cheap, the stock is a good holding. UBS acknowledges the improving inflation outlook provides some upside risk to forecasts but believes this is priced into the stock. The broker forecasts 4.0% industry growth in 2019/20, excluding tobacco and health. Market growth has improved and online channels are performing best.

Credit Suisse upgrades estimates for like-for-like sales to 3% growth for FY20 and 2.8% from FY21, in view of continuing consistent execution by Woolworths on several fronts, including digital.

Digital Strategy

Credit Suisse believes the major supermarket chains, Woolworths and Coles, ((COL)), are positioned to leverage their growing digital capabilities and establish a competitive advantage in the food retail chain. Promotional expenditure comprises 20% of the food retail value chain and there are material efficiency gains to be had through targeting consumers.

Woolworths Rewards program, Fly Buys in the case of Coles, provides customer identification and behavioural data can also be collected as a result of activity on the respective websites and use of shopping apps. The main difference is that Woolworths has internalised most of its digital capability and this reduces complexity.

In contrast, the independent grocers are relatively weak in digital business and likely to suffer a continued decline in market share as a result. Credit Suisse upgrades its long-term forecasts for sales growth for both Woolworths and Coles, and assumes Coles improves its profit margin relative to Woolworths.

The full story is for FNArena subscribers only. To read the full story plus enjoy a free two-week trial to our service SIGN UP HERE

If you already had your free trial, why not join as a paying subscriber? CLICK HERE