The End Of The WOW Factor?

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

By Greg Peel

Stock analysts can’t much like being given the job of analysing Woolworths ((WOW)). For the last few years it has simply not behaved as a stock of its nature should. Woolies is a “defensive” stock, categorised mostly under the heading of “consumer staple” on the back of its dominant supermarket business. Such stocks should be slow plodders on the upside, working off  a low margin-high turnover model, while also being unlikely to fall much in a downturn given everyone must eat.

Woolies does not deserve a high price-earnings multiple because it is just not a stock with the capacity for explosive upside. Or is it? All through 2007, as Woolies’ multiple pushed into the 20s, stock analysts kept calling the stock overbought on value. Yet it just kept going up, and up. From January 2007 to January 2008 Woolies shares gained 52% in value. Along the way, stock analysts were having apoplexy.

We all know the Woolies story. It has mercilessly elbowed aside small independent players in order to also dominate petrol and liquor. It has mercilessly cut farmers’ margins, and transporters’ margins, and all suppliers’ margins to the bone. It has taken control of its own supply chain. And most emphatically, it has mercilessly crucified its main opposition, leaving Coles ((WES)) a whimpering, dumbstruck mess. All along it has increased its market share, and its own profit margins. It has embraced food price inflation. It has constantly outperformed earnings forecasts. It has dominated. And it has won.

The ASX 200, of which Woolies is a valued member, fell 53% from peak to trough in the GFC. Woolies share price fell 31% before bottoming in June 2008. At that point, it was a different story from analysts as Woolies’ defensive characteristics came to the fore. The ASX 200 bottomed in March this year, and is now 42% higher. Woolies shares are only 19% higher from their trough. But the ASX 200 is currently 34% below its peak, while Woolies shares are only 20% below.

In every way, Woolies is a winner.

And still the company keeps posting strong results. Yet again, the FY09 result surprised analysts, rising 13% in profit terms from FY08 in the middle of a GFC. This time however, it wasn’t ridiculous earnings growth from the simple business of selling corn flakes and beer that surprised. Analysts have become programmed to expect ridiculous margin and earnings growth in Food & Liquor. It was the performance of Woolies’ New Zealand supermarkets and Big W that took the glory.

The NZ factor was simply one of an apparent turnaround in the fortunes of what has proven a difficult offshore asset for Woolies, notwithstanding a much more extensive economic downturn in the Shaky Isles. The Big W result was a surprise because this subsidiary franchise comes under the “consumer discretionary” sector tag, and consumer discretionary is meant to be a poor performer in a downturn.

But analysts must ask – once again, at risk of sounding like a broken record – can Woolies keep it up?

For those of you excited about the approaching Rugby League finals season, consider that Woolies is the St George of the retail world taken from a 1956-66 perspective (for the rest of us, that was a record run of consecutive Grand Final wins). Every year sports writers and punters must have bet against the Dragons, assuming it could not be possible to win again. The problem is, when you’re the best there’s nowhere else to go. The best has trouble improving. The best can only be looking to the downside. Finally, along came the 1967 Rabbitohs to end the party.

Woolies’ businesses are primarily cash generators. Cash does provide the sort of safety factor that deserves high multiples, but Woolies has rewritten the record books. As a private company, you’d simply be happy taking baths in the stuff. But as a listed company, you have to keep growing in order to keep shareholders happy. You have no choice but to spend that cash.

So Woolies is spending its money tarting up its stores, introducing more “private label” brands and loyalty programs and adding financial services. While Woolies is taking the opportunity to cement its position above a wounded Coles, it’s all mostly floss. Woolies has to look elsewhere for a new source of earnings, and having been defeated by the government on pharmacy it has now turned to hardware – one area Wesfarmers can actually claim dominance in.

Analysts agree hardware is a fair move but also that additional earnings will be minimal and won’t even be spotted until FY12. As for the rest of Woolies’ growth options, nothing will match the margins and earnings capacity of F&L. This means that every dollar Woolies spends on something else – and there is nowhere to go further on F&L – it is diluting its net earnings capacity. Being forced to grow for the shareholders’ sake means undermining overall value.

That is how many analysts see the Woolies story for FY10, almost with a dash of schadenfreude. This time, many suggest, they can’t possibly win the Grand Final again. And Coles is rising Phoenix-like (although it is no 1967 Rabbitohs just yet), and it was only government stimulus money that boosted Big W, and there is unlikely to be much food price inflation in FY10.

Woolies currently trades at a 15% premium to the All Industrials (ex banks) index, notes GSJB Were, but with an earnings growth expectation of only around 10% the broker does not see how Woolies can improve on its current 15x forward PE.

The glory days of the 20-plus PEs are behind us, as that was when the Woolies empire of petrol and liquor and Coles-kicking was at its growth peak. Macquarie notes Woolies’ gross profit margin has increased by 68 basis points since 2006, and this is meant to be a high turnover, consumer staple business. To put it another way, suggests Macquarie, some 42% of profit dollar growth since 2006 has come from margin expansion.

Yet Woolies does not disclose the metrics of volumes. The Macquarie analysts ask: where did this margin expansion come from? Higher prices? Lower cost of goods sold? Macquarie is one of only two brokers in the FNArena database that has a Buy (Outperform) rating on Woolies, but it does so with “some caution”. Macquarie doesn’t know how margin expansion has been achieved, so it can’t be sure of its sustainability.

UBS (Buy) does believe Woolies can do it again, suggesting hardware will help but also that capital management (share buyback, special dividend, something else) should come into play given all that cash. Woolies did actually increase its dividend at this result.

For all bar BA-Merrill Lynch (Underperform), Woolies is a Hold. There is general agreement that the market is pricing Woolies as it might have priced the 1967 Dragons.

Merrills has four basic reasons why it would sell Woolies shares: (1) The company is spending $2bn on store refurbishments etc against 10% earnings growth projections – not a good return; (2) The golden years of excess profit are over; (3) The “money tree” of F&L is being diluted by looking to new markets for earnings; (4) A 20% premium to the general market PE is no longer justifiable.

But…well…they’ve said it all before.

The average target price in the FNArena database is $29.71 with the last trade $28.06.

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