Can Woolies Get Its Wow Back?

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

– Woolworths' operational performance continues to disappoint
– Some analysts believe better prospects must be around the corner
– Others remain worried about too high expectations and management not adjusting
– Price targets from stockbrokers remain unusually wide for a retailer of staple products

By Greg Peel

It's a well known story. Woolworths ((WOW)) proved an extremely successful consumer staple company for many recent years, riding mostly off the back of a supermarket chain that was quietly grinding rival Coles into the ground. Stock analysts were often caught out as Woolies' price/earnings multiple pushed onward ever upward to levels unheard of for a consumer staple offering.

With Coles almost dead and buried, the question was as to how Woolies might be able to keep up its pace of earnings growth. Then along came Wesfarmers ((WES)) to snap up Coles and expectations of a rapid turnaround transpiring were not initially optimistic. Fears have since been proven unfounded, however, as Coles' come-back has seemingly gone from strength to strength.

Indeed, Coles sales growth numbers have appeared to blow Woolies out of the water. But one must remember that Coles is coming back from a very low, near death base while Woolies is trying to hang on to a base of dominance. Coles will report its March quarter sales numbers on Tuesday but the Woolies result, posted Friday, was pretty disappointing. Indeed, BA-Merrill Lynch (Underperform) believes it may well have been the worst quarterly sales result on record for the once gold-plated retailer.

Basically the result was one of flat growth year-on-year. Given management highlighted improving liquor market share over the period, the food element within the quintessential food & liquor sales measurement went backwards. Merrills analysts responded by suggesting “This result is disappointing and highlights our key concern towards Woolworths' deteriorating sales momentum”.

Woolies biggest problem in recent times has been that of food price deflation. Food prices are meant to inflate from year to year, not deflate. Aside from the impact of easing commodity price spikes from earlier years, Woolies has had to match a rival hellbent on slicing the margin on everyday items in order to draw lost customers back to the fold. Now that rival has moved on to press its claims on loyalty, with its FlyBuy cards, and Woolies will again be forced to respond.

This should signal an easing of the price deflation problem ahead, which is one factor some analysts are putting their faith in. Coles can't keep cutting prices forever. Aside from the impact of this competition there have been other issues to deal with, nevertheless.

La Nina has clearly been one of those issues. In the March quarter last year the country, and Queensland in particular, was awash. The impact for Woolies was actually a short-term positive due to the panic buying of groceries ahead of the floods. This served of offset the general backdrop of weaker consumer spending which has prevailed since the GFC, but also meant this March quarter's result was almost destined to look weak.

The consumer remains timid, and this March quarter the rains have returned and persisted with the impact this time being one of keeping the shoppers away. Management was certainly quick to play the weather card as it delivered its weak sales result, safe in the knowledge that the market would understand that weather is both uncontrollable and quite likely a temporary issue. But while analysts have acknowledged this factor, the question remains as to whether or not management's excuses are justified or whether deeper underlying issues are chipping way at the struggling retailer.

Realistically a lot comes down to whether things can improve in FY13, which assumes more stable weather and the aforementioned easing of price deflation. 

RBS Australia (Buy) seems to think so, agreeing with management's forecast for a return to double-digit sales growth across the operations. RBS sees the deflation factor diminishing and the benefits of strategic initiatives with respect to supply chains and marketing kicking in. Cost reduction programs should also provide material benefits, RBS believes, the New Zealand supermarkets continue to grow strongly, Victorian gaming reform will provide a one-off kicker, and there's even an extra trading week in FY13. The analysts don't see any upgrades ahead in FY12 but suggests downside is also limited.

Citi (Buy) suggests the March quarter may have represented the food & liquor sales trough. Big W sales appear to have stabilised, which is good, although Citi believes Big W is vulnerable to the growth of online and needs to look at reducing lines and stores. Masters hardware is looking a bit soggy now too, the analysts admit, after the honeymoon. Might Bunnings (WES) prove too tough a nut to crack?

At the end of the day, Citi also cites Woolies' defensive characteristics of reliable earnings and strong cash generation. JP Morgan (Overweight) agrees, albeit admitting June quarter sales are likely to be weak for the company as well.

JPM is confident new CEO Grant O'Brien can deliver on strategy priorities. In the shorter term, however, price deflation must continue given produce prices were forced up by floods this time last year, the consumer environment is still weak, and Woolies is suffering from a cannibalisation effect from the recent rollout of new stores. Deutsche Bank (Buy) is also putting its faith in the CEO's strategies.

UBS (Buy) is also looking for a return to double-digit earnings growth in FY13 and is not alone in pointing out Woolies shares are trading at the bottom end of their range based on ten-year historical PE relative to the market.

Macquarie is happy to sit at Neutral post the sales result but Credit Suisse joins Merrills in remaining on Underperform.

Credit Suisse points out that Woolies will bear a cost from trying to re-accelerate its sales growth and this is just not being factored in by the market. The analysts also point out that earnings growth forecasts are not taking account of wage growth forecasts, with new award rates taking effect from July. The analysts believe consensus forecast for 8% earnings growth for FY13 and FY14 appear too high (remembering that at least a couple of brokers are up in double digits).

The bottom line for Merrill Lynch is that management's focus on cyclical factors as the issue, as sales slow significantly, and not on the current change in its competitive operating environment is concerning. Management's faith is leading to a continuing focus on sustaining high margins while heavily investing in new stores and store refurbishments. 

Merrills points out that UK equivalent Tesco's tried to respond in a similar fashion, but has recently “capitulated” to lower margins in order to re-stimulate sales growth.

So while five Buy (or equivalent) ratings in the FNArena database outweigh a Neutral and two Sells, the jury is still largely out on Woolies. Most brokers have trimmed their FY12 earnings forecasts but the consensus target is little changed at $27.13, albeit on a spread all the way from $22.00 (Merrills) to $29.80 (RBS). This is not a miner we're talking about, but a company that sells milk and bread.
 

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