Woolworths Comes Clean. Now What?

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

In this week’s Weekly Insights:

– Woolworths Comes Clean. Now What?
– Reporting Season Special
– Orica’s Glencore Concentration Problem
– Copper: Improving Fundamentals
– Radar On Buy-Backs
– Rudi On TV
– Rudi On Tour

Woolworths Comes Clean. Now What?

By Rudi Filapek-Vandyck, Editor FNArena

The most important event during this year’s February reporting season happened on the final Friday when supermarket operator and SMSF darling Woolworths ((WOW)) finally admitted its management team had been living in the past for far too long and that pulling the company forward is going to require one helluva lot of effort, and investments.

Given the shares have proved somewhat of a market favourite over the past fifteen years, with margins, profits and dividends steadily increasing over the period, it is probably fair to assume most SMSF shareholders, and the financial advisors who guided them into owning Woolworths shares, are currently relying on the experience of the past fifteen years when they make up their mind whether to hold on or to hold on with doubled conviction, and maybe buy some extra shares since they now are so “cheap”.

Let there be no mistake. Friday’s shock profit warning by Woolworths marks an important turning point in how the market outside the loyal SMSF shareholder base is going to view this company and its damaged outlook. Whereas previously share price weakness had been solely due to “market speculation” and “investor sentiment”, post Friday this is no longer the case. Woolworths is now officially in “repair” mode.

It’s official. They dropped the ball. Hung on for too long to what was perceived as an impregnable market leading position in Food and Liquor. Post Friday, now there is a dent in the armour. A serious one.

There is no clearer illustration for this than the chart below from Monday’s research update by Citi. Observe how the loss in market share started accelerating from the third quarter of FY14 onwards.

Here is the same information in a different format:

Woolworths is now clearly trailing Coles and Aldi. Reversing the trend is going to require extra investment, which is going to weigh on cash flows and on profits. Meanwhile, loss-making Masters and troubled Big W still need to be fixed too.

The Next Chapter: De-rating

After the news and sharp punishment by the market on Friday, I made a few quick calculations and thought the share price is likely going to drop into the $28-29 range. Part of my consideration is that at those share price levels the forward looking implied dividend yield rises to be around 5%. Add franking and there should be a small army of advisors and yield hungry SMSF operators ready on the sidelines to jump onto what they believe has now turned into a bargain.

No doubt, this view will be supported by the fact the shares were seemingly heading for $40 only twelve months ago when they surged above $38 in April 2014. Surely a stock like Woolworths (“low risk” and with a commendable track record, etc) that falls from $38 to below $30 in such a short time-span, must now by definition represent excellent value for longer term investors?

Cue financial advisors that line up all kinds of bogus arguments like “consumers won’t stop buying alcohol and food” and “Woolworths is still going to be around in ten years time”.

Every comparison is by definition imperfect, but I believe for the closest example of the market process that is now reshaping Woolworths, investors should look no further than Coca-Cola Amatil ((CCL)).

Arguably, Coca-Cola Amatil under CEO Terry Davis had it all going smoothly, at least on the surface, but ill-advised expansion into unfamiliar territory (sounds familiar within the Woolworths context?) -food processing- plus an Indonesian problem that simply would not resolve itself were ultimately too much to deal with when consumers in Australia started rethinking their sugary drinks consumption.

Coca-Cola Amatil equally had a long track record of consistent shareholder returns and solid, reliable dividends but its own moment of having to come clean occurred in 2013. The result was a big down-year in FY13 and dividends had to be cut in the following FY14. The share price, during that time, fell from beyond $15 to below $9. In recent times there has been a bounce back above $10.

I think a similar trajectory should be assumed for Woolworths shares. To date the share price decline from $38 is in excess of 33%. Note that CCL’s share price loss exceeded 40% (this does not imply Woolworths has to fall by exactly the same percentage). Note also that Woolworths’ down-year will be FY16, not FY15. So the trough is still ahead of us, with more bad news to follow, no doubt.

The chart below shows the various cycles of Price-Earnings ratio (PE) re-rating and de-rating that have impacted on Woolworths’ share price between 2000 and late February 2015. While the PE, on my own calculations using live FNArena data at the time, exceeded 27 in the heydays of 2007, it has subsequently been as low as 13 in the post-GFC de-rating, just before the international search for yield pushed up the PE to circa 18, and kept it there until one year ago.

Now that analysts have recalibrated their estimates, and investors have sold down the shares by some 15% in two days, Woolworths PE now sits above 15, both for FY15 and FY16, with consensus anticipating no growth and a relatively steady dividend outlook of 137-138c for each year. The latter translates to 5.1%, plus franking.

The Future Is All About Margin

One reason why investors tend to underestimate the risk that overhangs the Woolworths share price is because a large industrial oligopoly member such as Woolworths or Coca-Cola Amatil tends not to report a 47% deterioration in net profits, like BHP Billiton ((BHP)) just did, unless there are impairment charges involved. Impairments are certainly possible further down the road if loss-making Masters cannot be fixed or if partner Lowes decides to pull up stumps.

What should be of concern to investors is the fact that Woolworths’ Food and Liquor division operates on an exceptionally high margin of 8% (EBIT) and with the pressure to lower prices and to re-invest in reinvigorating the business, those margins can only go south from here.

Woolworths sells in excess of $60bn in consumer goods each year, and F&L accounts for some 78% of total group profits, thus what happens to the F&L margin is now largely going to determine the outlook, PE and perception of the company and its share price.

And with nearly 80% of $60bn on a world beating margin, small changes can make a big impact.

Below is the share price sensitivity guide as published by UBS analysts in response to Friday’s shock announcement. UBS effectively assumes the PE remains unchanged, showing a 50bp deterioration in margin should take the share price to $27. Assume 50bp more, and two more dollars go off the Woolworths fair value valuation.

But, of course, the PE can go lower. In fact, on FNArena’s consensus forecasts revised post Friday, the PE already has fallen to 15 (see Stock Analysis on the website). If things do not turn around quickly or competitor’s responses draw the food and liquor sector into a fierce pricing war, a la Qantas versus Virgin Australia, then both PE and margin and profits can fall a lot further.

This is pretty much the view analysts at Morgan Stanley have taken. Under such a scenario, the share price can fall a lot further, still. Also because it will ultimately force Woolworths into cutting its dividend to shareholders. Morgan Stanley has taken the view that Woolworths is now ex-growth and it shall remain ex-growth until 2020. Where the share price shall be by then is very much dependent on how much margin erosion is about to take place over the five years ahead.

If margin erosion is very small, the Woolworths’ share price is likely to trade around $30, on Morgan Stanley estimates. If margin erosion is modest, Morgan Stanley calculates a fair value destination of $24. If margin erosion turns out genuinely bad, the share price is doomed to go back to $20.

No need to ask about the prognosis of Morgan Stanley; the analysts lowered their price target to $24. The above mentioned analysts at UBS have reset their price target at $28.50, but the following quote provides a better insight into their thoughts about the outlook for Woolworths:

“Most likely, in our view. We believe WOW margins are too high and that the Australian F&L market is entering a period of structural change. Under the scenario where WOW re-based Aust. F&L margins by c100bp and the stock de-rate we see scope for WOW to trade towards $25 per share.”

Stockbroking Analysts Respond

Stockbroking analysts receive a lot of criticism, mostly for being too slow when trends turn, but in case of Woolworths, warnings were issued before Friday’s results release. Morgan Stanley, for example, cut its target to $27 before the event, and then had to conclude it still wasn’t low enough. UBS warned its clientele Friday was likely going to be a clear “miss”.

Both warnings had been published in FNArena’s Australian Broker Call. This is one opportunity I cannot let go unmentioned that taking a paid subscription, $370 for a whole year, and reading the Australian Broker Call, five days a week, can prove its value many times over.

Otherwise, the analysts’ responses post Friday can probably be best described as a general reset of expectations and projections. There is not one report on Monday that somehow suggests this is not serious damage. As said above, estimates have dropped and there is general agreement that repairing Woolworths is going to require time.

Unlike Coca-Cola Amatil, Woolworths cannot call headquarters in Atlanta and ask Big Momma for some strategic, financial assistance.

In the meantime, everybody will be watching Woolworths margins with hawk eyes.

As things stand right now, the company will struggle to post any gains in profits this year and next, and it may not raise its dividends either. The consensus price target has now fallen to $29.59 from $33.95 on Friday. Ratings have been pulled back (of course).

What Should Investors Do?

Given the above, it should not surprise the Woolworths share price now starts with a ‘2’ instead of a ‘3’. With the share price down some 15% in two days, and the implied forward yield now above 5% (ex-franking), it’s probably a fair assumption that, for the time being, most of the damage has been done.

From the moment the share price stops falling, the “bargain hunters” and “yield seekers” are likely to move in, which is probably going to provide support, for the time being, around current levels.

Note also that Woolworths may have announced it is going to face its competitors mano a mano, management has not provided any details about the how or what behind the new strategy. More should be forthcoming on the Annual Strategy Day, scheduled for May 6. Prior to that date, Woolworths will release its Q3 sales update on April 29.

Probably a fair assumption the share price is going to move side-ways ahead of both dates.

Investors who bought in long time ago are likely going to take a long term view, relying on the solidity of the dividends and in the knowledge this company has one of the best track records over the past 15 years. Such a strategy is valid, but it should be clear from all of the above that risks remain high and success is far from guaranteed. The past 15 years certainly happened in a different context than the five years that are ahead of us.

Time to take note of an old worn out market truth: if you don’t like bad surprises, do not mix dividends with operational weakness.

For investors who do not own Woolworths shares today, I would suggest do not fall for the temptation. There are plenty of lesser risk options in the Australian share market. No need to play the hero.

Reporting Season Special

Woolworths’ finally revealing it has been swimming naked since last year is without any doubt the most important event of this year’s February reporting season. A more general assessment of the reporting season shall be written and published later this week. Watch this space.

Orica’s Glencore Concentration Problem

A too high concentration of customers or profits. It’s usually a risk that comes attached to medium, small and micro caps. The past few weeks have seen some of such risks come to light at companies including OzForex ((OFL)) and Genworth Mortgage Insurance Australia ((GMA)), with share prices re-setting at significantly lower price levels. Navitas ((NVT)) is another example that springs to mind.

Orica ((ORI)) is a Top 40 member on the ASX, but judging by a research update from Morgan Stanley, investors might have to ponder exactly how much concentration of risk is there attached to the provider of mining services?

Consider the following series of observations, published in the wake of Glencore announcing a significant reduction in its Australian thermal coal output; the 15mt cut equating to 7-8% of Australian seaborne production, point out the analysts at Morgan Stanley. And the importance for Orica?

Well, points out Morgan Stanley, Orica generates some 75% of its Australia & Pacific profit from the east coast with much of this generated from thermal coal. Circa 70% of Australia’s seaborne thermal coal is produced in NSW where the analysts estimate Orica holds a  market share of 90-95%.

Morgan Stanley sees additional downside risk because of increasing competition and the ongoing downturn for the mining sector, pointing out the ammonium nitrate (AN) operations have a fixed cost base so any downward impact will cause a much larger impact on profits.

The stockbroker has now positioned itself well below market consensus, suggesting the financial year to September 2015 (FY15) will only see earnings per share (EPS) of 137c against consensus at 159c. And can you believe it, Morgan Stanley still maintains it may well need to lower that number further.

Note: Orica announced a share buy-back on Monday.

Copper: Improving Fundamentals

This might come as a surprise to many, but the average annual growth in copper consumption over the past decade is only 2.5%. Note this is including Super Cycle China’s emergence post 2003. Incredible, but true, average demand growth for aluminium over that same period has been twice as high.

One would not think such is the case when looking at the price performances for both major metals. So what’s been driving the price of copper if not insatiable demand from China?

In two words: disappointing supply.

And copper producers in early 2015 are back at doing what they do best; missing production targets and reporting delays, closures and interruptions.

Here’s a brief overview from a recent sector update by Citi:

“Rio cutting Kennecott’s expected output by 100,000 tonnes, BHP cutting 150,000 tonnes from Escondida’s 2015 outlook, while Glencore has cut guidance at Minera Alumbrera by 50,000 tonnes. BHP Billiton announced a 6-month care and maintenance outage at the Svedala mill, the largest of three mills on site at the Olympic Dam facility in Australia. This operational disruption is likely to cost the mine c65,000 tonnes of copper concentrate.

“Closures have occurred at Mineral Park, Boseto, Aranzazu, Wolverine, Troy and Dikulushi. Barrick has placed it 135,000 tpy Lumwana mine on care and maintenance due to introduction of a 20% royalty rate on open pit mine operations in Zambia, up from 6% previously. This royalty rate move has prompted a freezing of mine investment in Zambia, and we believe will prompt further production losses through the year if the policy is not reversed”.

So far, it appears the market hasn’t paid much attention to all of this, instead taking lead from macro-issues, including Chinese New Year. At some point, however, this is likely going to change.

Citi analysts, for their part, expect increasing supply problems to be “highly supportive” of copper prices, probably in the second half of the year. On Citi’s projections, copper should revisit US$7,000/t before year-end.

Radar On Buy-Backs

Not every share buy-back is the same. That much I am willing to concede. At times, when a company is in trouble and no reliable growth prospects seem on the horizon, buying back own shares merely limits further downside. In most cases, however, market outperformance is the ultimate consequence.

CEOs in the US know it. Just about every quant analyst who has done the data analysis knows it too. Share buy-backs are beneficial for performance.

Last year I ran a regular update on local share buy-backs in this weekly story, with some participation from subscribers and readers; thank you for your assistance.

Some readers, however, complained that I should focus on whether buying back own shares was actually the right thing to do. The suggestion here was that if a company bought its own shares at too high a price, an opportunity was being wasted and there should be no outperformance, but the opposite instead.

While I can sympathise with such view, and it certainly seems to make a lot of sense -within an academic context- I actually find there’s very little evidence supporting such good/bad buy-back assessments.

Sure, if iron ore prices collapse tomorrow, it won’t stop shares in Rio Tinto ((RIO)) from falling, even those shares look relatively undervalued and the board is thus doing the right thing, seemingly.

But companies including Telstra ((TLS)), CSL ((CSL)) and Amcor ((AMC)) have been buying in own shares for years now, and in each of these cases it can be argued there’s no undervaluation and those companies are buying in at too high prices. It has not stopped each of them significantly outperforming the broader market.

So what’s all this fuss about companies should only buy in when their share prices are cheap and undervalued? Isn’t the irony that if a company is in good shape, and has plenty of excess cash, its share price by definition won’t be undervalued? Happy to start up a discussion about this. All contributions welcome at info@fnarena.com

In the meantime, here’s my starting overview of share buy-backs in 2015 (all contributions, corrections and additions, welcome at the above email address):

– Amcor
– Fairfax ((FXJ))
– GDI Property Group ((GDI))
– Nine Entertainment ((NEC))
– Orica ((ORI))
– Rio Tinto ((RIO))
– Seven Group ((SVW))

Rudi On TV

– on Wednesday, Sky Business, 5.30-6pm, Market Moves
– on Thursday, Sky Business, noon-12.45pm, Lunch Money

Rudi On Tour

I have accepted invitations to present:

– Wednesday, 11 March to members of Chatswood section of AIA, in Chatswood (evening)
– August 2-5, AIA National Conference, Surfers Paradise Marriott Resort and Spa, Queensland

(This story was written on Monday, 2 March 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena’s – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena’s bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today’s share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

Making Risk Your Friend. Finding All-Weather Performers, in both eBooklet versions, is included in FNArena’s free bonus package for a paid subscription (excluding one month subscription).

If you haven’t received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of January available. Just send an email to the address above if you are interested.

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