And Again We Say WOW

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

By Greg Peel

“All in all, it was a near flawless sales result,” said Credit Suisse. The result was “probably the best operating performance that we have ever seen,” said BA-Merrill Lynch. Other brokers offered equally effusive commentary.

In the middle of a recession, Woolworths ((WOW)) posted a 5.9% sales increase in the March quarter. Take out petrol, which is suffering from both lower demand and a lower price, and the result was 8.3% growth. Not only did Woolies increase the number of customers through its doors, customers increased their “basket size”, meaning the number of items purchased in one visit. New Zealand dragged, but department store Big W posted a strong result.

These numbers, suggest analysts, reflect various factors. Firstly, government stimulus has encouraged more spending. This spending has nevertheless not been indiscreet, as consumers have turned to a discount store like Big W for its purchases, and Australians are also spending more in the supermarket as they choose home-cooked over restaurant, cafe or pub meals. Australians are battening down the hatches, and Woolies is a beneficiary.

As this trend plays out, Woolies is further luring the available customer base with store refurbishments, Tesco-style loyalty programs and greater emphasis on fresh produce. This program will still only be 40% complete by June. Woolies is winning  a greater share of the pie while rival Coles ((WES)) continues to languish, and Coles has to first turnaround before it can even contemplate matching Woolies on store upgrades.

Coles is telling analysts it’s on the improve. But Merrills has heard the opposite from both Coles’ competitors and its suppliers. “It appears that the only ones saying Coles is going okay,” says Merrills, “is Coles”. But while this might draw a sadistic grin from Woolies’ management, Merrills suggests it could also cause Woolies a bit of a problem.

Woolies is moving further and further away from Coles in its performance. Coles thus has two choices, says Merrills, either concede and let Woolies be the best, or attack with an all-out price war assault. The former is unlikely, given the ambitious targets Wesfarmers has set for Coles, and the latter would cause industry-wide returns to “materially suffer”, suggests Merrills.

Merrills has also previously drawn attention to the markets’ net earnings expectations for the supermarket industry over the next few years, which are actually greater than over the past few years when supermarket growth boomed. Such expectations assume all participants will achieve their potential together, when reality suggests cannibalisation can be the only outcome. See “The Great Supermarket Fantasy” (Australia; March 31).

At the same time, more than one analyst has noted that “a rising tide floats all boats”. While Woolies is the stand-out, the increased patronage of supermarkets and discount stores by Australians in the recession is beneficial for all sector players.

Oddly enough, Woolies’ share price has underperformed of late. This is not surprising however, given the 20% rally in the ASX 200 since early March. Woolies attracted support from investors as a “defensive” stock when the index was falling. The latest rally suggests a return to some level of risk appetite, meaning investors are switching out of their defensives and into risk plays such as banks (yes – they are a risk play in this GFC) and resources.

Ironically, UBS calculates this to mean that Woolies is now trading at a 15% discount to Coles. To arrive at this conclusion, UBS has to assume net present value for Wesfarmers’ coal business and a PE multiple of 10x for its other businesses. If the analysts’ conclusion is justifiable, this recent sales result should spark some life back into Woolies, but UBS warns that this is unlikely to happen if the stock market continues to rally and investors look for risk.

What this underperformance has done is to bring Woolies’ once elevated PE multiple back to the pack. Deutsche Bank believes Woolies is deserved of a 19.1x multiple on a discounted cash flow basis, but that the current 16x (FY10) is fair given overall weaker market sentiment will prevent investors from paying up. This makes a difference such that Deutsche is setting a $27.70 target for Woolies instead of the $32.20 implied by its DCF valuation.

No one in the FNArena database has a Sell on Woolies. Ratings are split 5/4 Buy to Hold, with the Buy-raters finding it hard to argue against the company’s superiority and ongoing runs on the board while the Hold-raters suggest this is about where the price should be. The average target has ticked up following the sales result, from $29.45 to $29.54. Woolies is trading around $26.30 this morning.

In the longer term picture one is forced to ponder just how long Woolies can keep sucking all the oxygen out of the sector. The company is currently refurbishing stores if for no other reason that it has to spend its money somewhere. There are no further apparent opportunities to expand sales lines (assuming the government will always knock back pharmacy) and offshore acquisition is fraught with danger. Refurbishment is ensuring Coles’ turnaround is facing an ever higher mountain but then what does Woolies do next? It is incumbent upon listed companies to keep growing earnings. Is there an Icarus event ahead?

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