Food Sales Growth Falters At Woolworths

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

Food remains central to the market's concerns regarding Woolworths, as previously robust supermarket sales growth falters in the first quarter of FY19.

-Slower supermarket sales in first quarter affected by factors considered "one-off"
-Elevated costs growth remains a concern
-Opportunity to drive growth through efficiencies not yet evident
 

By Eva Brocklehurst

Supermarket sales growth for Woolworths ((WOW)) appears to be plateauing and moderation is expected in FY19 as competition in food intensifies. The first seven weeks of FY19 showed growth of just 1.3%, which is now behind rival Coles ((WES)). Meanwhile, Coles appears to be on the rise.

Food is the centre of the market's concern regarding Woolworths. Australian food revenue grew 4% in FY18 while operating earnings (EBIT) grew 10%, below many forecasts.

Like-for-like sales, comparably robust and averaging growth of 4.3% over FY18, appear under pressure. This is been affected by significant deflation in fruit and vegetables, the removal of the plastic bag bans, which have affected items per basket, and amid the very successful Little Shop promotion from Coles.

Woolworths may have lagged Coles, which grew 2.4% in the first quarter, for the first time in two years but Credit Suisse is not overly worried, given the performance was potentially held back by the aforementioned factors.

The broker believes Woolworths is a solid long-term story, albeit its near-term performance is stymied. Additional expenditure on e-commerce and warehouse automation are expected to widen the competitive advantage with respect to Metcash ((MTS)).

Citi also expects the gap to Coles to be short lived, as those previously outlined factors cease to affect sales from the end of August. However, elevated growth in the cost of doing business (CODB) is a concern. Cost benefits from the investment in distribution centre infrastructure are expected to drive a flat outcome in FY20 for CODB/sales for the first time since FY14.

UBS downgrades to Neutral from Buy, observing Australian food CODB growth outstripped sales growth. While continuing to believe there is an opportunity to drive efficiencies, the broker points out this is not yet evident. For UBS to become more positive requires a tangible sign of returns on investment being achieved in the form of increased customer loyalty, cost reductions and gains in working capital.

Deutsche Bank is more positive and does not believe the recovery for Woolworths is over. The broker suggests the business is continuing to please customers, as they chase free plastic bags and toys. Sales growth is expected to improve in the second quarter when the headwinds have passed. Still, the broker downgrades to Hold from Buy.

Competition

Shaw and Partners, not one of the eight stockbrokers monitored daily on the FNArena database, maintains a Sell rating and $27.75 target. The broker does not expect Coles, Aldi or the Metcash-supplied IGA to take a backseat to Woolworths.

Australia is a second most concentrated grocery market in the world behind New Zealand and competition is expected to become far, far more aggressive. Moreover, Australian supermarket margins are still high on a global basis. The broker also believes strategies to turn Big W around are uncertain and the discount department store is likely to be a drag on the company's profitability at least into FY19.

Credit Suisse admits its excitement at seeing the earnings (EBITDA) loss at Big W reduced to -$30m dissipated when the increase in capital expenditure to $95m was noted. The broker agrees cash break-even is still some way off, although expects FY19 will provide a better indication of whether Big W is sustainable.

While the turnaround over the past two years was impressive, Morgans believes the stock is fully priced relative to its earnings growth profile. Morgans was pleased with the $0.10 special dividend and that the company is considering further capital management as part of the exit from the petrol business.

Capital Return

Citi does not foresee gross margins rising above 30%, given the competitive nature of the industry. The broker suspects a capital return may occur in the second half, via a small special dividend, which could set the stage for a more material return post the divestment of the petrol business.

Yet, while capital management may entice some investors, Macquarie believes the outlook is questionable. The broker believes an eventual recovery at Big W or a turnaround in New Zealand are not large enough in isolation to matter.

Macquarie does not expect margin expansion will occur in food. The business has highlighted a need to continue investing in order to improve the customer experience and the broker believes this will hinder margin expansion.

Ord Minnett also expects the earnings margin to narrow in FY19 because of rising costs, tough comparable numbers and a more competitive Coles. Nevertheless, the broker believes the company's investments are sound uses of the growth in sales, while lower inventory losses will aid gross margin expansion and sustain the turnaround in food.

What Metric?

As an aside, Shaw and Partners is not a fan of the like-for-like comparable metric. The broker believes the market's obsession with this numeral can be manipulated by the closure of underperforming stores, treatment of refurbishment and online sales, as well as promotional periods or discounting activity.

The broker prefers to focus on underlying operating metrics such as sales per square metre, operating earnings (EBIT) margins or return on invested capital (ROIC). The broker suggests low single-digit growth in earnings per share at Woolworths does not deserve a price/earnings ratio of 21x.

FNArena's database has six Hold ratings and two Sell. The consensus target is $28.47, signalling -1.4% downside to the last share price. Targets range from $23 (Morgan Stanley, yet to comment on the results) to $32 (Citi).

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