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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.

While Coles is upgraded to Neutral , a Neutral rating is retained for Woolworths and Metcash, which serves the independent sector, has been downgraded to Underperform.

UBS differs, moving Metcash to the front of the sector as it offers the best near-term exposure to inflation. Woolworths' execution is strong but it is very difficult to achieve sustained price increases, despite the improving inflation outlook and the broker has downgraded Woolworths to Neutral.

Competition

While the Australian grocery market has been rational over the past year, Citi expects, disruption to intensify once Kaufland enters the market in 2021. Kaufland has a 110,000 square metre distribution centre and nine stand-alone sites under construction. The distribution centre will provide sufficient capacity to support around 190 stores, likely to be a catalyst for a return to private-label price competition and this will weigh on earnings margins.

The broker downgrades long-term earnings margins by -20 basis points to 5.1% for Woolworths and downgrades to Sell. Coles is similarly downgraded to Neutral. Citi factors in investment by the major supermarkets in private-label pricing in order to compete with the newcomers, which will be a headwind to sales growth. The broker also points out that Lidl has followed Kaufland into each new market after around five years.

FNArena's database shows four Hold ratings and four Sell for Woolworths. The consensus target is $29.91, signalling -5.7% downside to the last share price. Targets range from $26.84 (Macquarie) to $32.90 (UBS).

See also, Big W Still A Headache For Woolworths on April 2, 2019.

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