Any Growth Ahead For Woolworths?

This story features WOOLWORTHS GROUP LIMITED. For more info SHARE ANALYSIS: WOW

By Andrew Nelson

Woolworths ((WOW)) delivered an anywhere from good to strong first half result a few days back depending on who you ask. There was a solid performance from the group’s all important Food & Liquor division, with gross margin gains also recorded across all divisions. Yet after the result no upgrades were made, in fact the only change to broker recommendations was a downgrade to Sell, moving the stock to a negative footing on the FNArena Sentiment Indicator for the first time in a long time.

The obvious question is: why after a good result has sentiment for Woolworths pulled back that little bit more?

The quickest way to arrive at an answer is to look at what analysts from Citi had to say in making their decision to downgrade to Sell from Hold. The short answer is valuation, the broker noting the shares have re-rated significantly over the past three months.

Dig a little deeper and one gets the impression a Hold call might have been maintained but for one factor: the growth outlook is pretty much unchanged. While Citi finds Woolworths to be well-managed company, the fact remains that it is also a mature company that generates a predictable 5-7% EPS growth per year. A steady performer, yes, but the broker can’t see a FY14 PE ratio of 17.5x as being supported by these levels of growth.

One of the key issues keeping the broker on a conservative earnings stance is that losses from Masters seem to have accelerated in the 1H to an estimated  $65m. This compares to a loss of $50m in 2H12. Extrapolate out the numbers and Citi is predicting a $112m loss for Masters in FY13, which is well ahead of the $80 million the company has guided to. ACCC scrutiny and accelerating industry-wide store openings appear to be being ignored, says Citi, who points to the rising share price.

The other earnings problem Citi sees is the fact that the Food & Liquor result was delivered on the back of what the broker found to be impressive cost controls. However, sales are slow and thus the sacrifice is less operating leverage once/if sales growth beings to accelerate again.

BA-Merrill Lynch, also at Sell, is in line with Citi in its concerns about what is a very flat sales growth environment. Thus, much like Citi, BA-ML is also of the opinion that cost cutting and margin increases, while supportive for the moment, will erode the company’s ability to lifts sales growth from currently languishing levels. The ongoing heavy capex push to roll out new stores and renovate existing ones is likely to be a “keep the head above water exercise”, not a driver of the next leg of growth.

$1.85bn on new stores and refurbishments, and put towards Hardware and Property Developments, seems a pretty steep price tag to maintain these low levels of growth. The broker is further troubled by only $384m being spent on “keep the stores running” capex, which is where the real upside of sustainable cost efficiencies would come from.

Credit Suisse, also at Sell, is also worried about where the money is being spent. The broker has trouble with the  current  levels of expenditure on things like broad-based promotion, noting this is likely to be insufficient  to  maintain the group’s market position. The broker does, however, see upside if current sales trends and retail activity levels continue into later this year.

On the other side of the street, Deutsche Bank, who sits at Buy and could find little fault in the 1H report, liked the margin expansion booked across every division and liked earnings growth of more than 6%. Sure, the retail environment remains challenging, but after getting off to the start it has, the broker thinks FY targets are conservative, especially given current momentum appears to be improving, while the broker also expects a larger benefit in the 2H from gaming licence changes.

Longer term, which is where the Sell call gang has their problems, Deutsche is growing increasingly confident management’s strategic initiatives are delivering tangible benefits. Thus, the only major downside risks the broker sees are lower food inflation, weakening consumer confidence and the risks associated with rolling out Masters.

Macquarie, also at Buy, sums its view up by noting the market still wants to buy high yield and low earnings volatility in stocks that offer a high payout ratio. In assessing these “safer” yield plays, the broker notes the investors want to see credibility and predictability. Sure Woolworths is an expensive defensive yield play, but it’s worth the price, says the broker.

That’s not to say Macquarie isn’t worried about where FY13 growth will come from, but over the half the broker saw margin expansion coming from a number of areas, although a more important factor was gains from the terms of trade with suppliers. Given the view supplier margins are far too rich, the broker sees more upside to come from this area over the year ahead

UBS, currently sitting at Hold, continues to believe the stock looks expensive relative to peers in FY14. On the other hand, with the company already tracking at the top end of the FY13 guidance range and given the scope for positive surprise, there is little that could cause any sort of near term underperformance.

CIMB, also at Hold, notes the stock is trading at a 21% PE premium to the S&P/ASX  200, or just under its five-year average of 27%. A fair price, but certainly not expensive, especially given what was outside of Masters, a very solid interim result.

Goldman Sachs, has maintained a Hold call. The broker notes most of the upside is being driven by what is moderating growth in the core Australian Food and Liquor business, with the Home Improvement and Hotels divisions expected to pitch in and deliver a bigger share of the upside. The problem is: both of these divisions have a greater level of earnings risk associated with them.

GS points to a 10% premium to the All Industrials ex-Banks and an FY14 PER of 16.1x. The difference in opinion from those at Sell is that GS sees current multiples as representing fair value, noting overall that returns remain strong and the balance sheet offers some nice capital management potential in the medium term.

The FNArena Database shows Three Buy calls, three Sell calls and a pair of Neutrals. The Sentiment Indicator reading is 0, meaning flat neutral, with shares currently trading at a 10.1% premium to the consensus price target.

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