Better Outlook For Woolworths Supermarkets

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Industry feedback suggests Woolworths supermarkets had a better time than Coles over Christmas. Woolworths has also announced it will divest its petrol stations business to BP.

-More focus on sales versus margin at Woolworths, with turnaround in train
-Question of how Coles responds to Woolworths' improvements
-Woolworths petrol divestment to BP could help Metcash
 

By Eva Brocklehurst

Woolworths ((WOW)) increased both the frequency and depth of discounting in the Christmas quarter and the company appears far more focused on sales as opposed to margins, Morgan Stanley observes. Higher promotional activity and the successful launch of the loyalty program should boost second-quarter supermarket like-for-like sales growth.

The broker now forecasts Woolworths' supermarkets delivering like-for-like sales growth of 1.5% versus 1.0% for Coles ((WES)) food and liquor in the second quarter of 2017. This signals the first time since 2009 Woolworths has outstripped Coles. Morgan Stanley retains a Underweight rating, suspecting FY17 margins will be disappointing.

From its surveys of supermarkets, UBS believes the turnaround has begun for Woolworths and the projected pace of relative improvement versus Coles may prove too conservative. The question is whether, and how, Coles responds. Woolworths has lifted its overall score on the broker's survey and closes the gap to Coles, with a strong performance across the board. Importantly, Woolworths improved in key customer-facing areas such as price, on-shelf availability and in-store compliance.

Staff morale also lifted, which signals to UBS a better performing business with a clearer direction. To some extent these trends were expected, given the magnitude of the company's investment in this area over the past 18 months, but the pace of the turnaround has come quicker than that implied by UBS estimates.

The broker notes Coles still leads the market in its ranges, formats and marketing but that lead is shrinking. UBS expects sales at Coles to revert to mean unless it incorporates a strategy to again leap ahead of both Woolworths and Aldi.

UBS highlights the performance of Coles, with relative declines across all nine of the survey themes, does not signal the company is doing anything wrong, rather it means no change in the company's strategy to combat a better-capitalised and more customer-focused Woolworths, as well as the step-up in intensity by Aldi in fresh food. Should current trends continue, UBS believes Coles may need to react in the form of margin investment or capital expenditure, particularly given both Aldi and Woolworths are accelerating refurbishments.

Suppliers were clear in signalling to UBS that Woolworths traded better over Christmas and while the broker envisages only modest downside risk for Coles' like-for-like sales in the second quarter, the pace of improvement at Woolworths signals both sales and margins could recover more quickly than previously realised. Nevertheless, UBS has not made revisions to its estimates as yet. The test will be for Woolies to maintain the momentum in 2017 as price investment eases.

The fresh food sector was the only negative for Woolworths in the survey, a surprise to UBS. This is an area the broker hopes will improve, particularly given the investment Aldi is making in fresh food. The broker believes a price war is looking less likely as Woolworths has undertaken major investment and has signalled it would be more rational beyond the first half.

Moreover, input pressures are rising via raw material costs, logistics and labour and suppliers are also now forecasting flat shelf price inflation over the next 12 months compared with the 0.2% deflation noted in the June survey.

Macquarie revises its expectations for comparable store sales growth in the second quarter, reflecting its own feedback from a broad range of channel checks. While Woolworths has improved its execution on a very poor performance from the prior Christmas, Coles is likely to find further improvements a tough hurdle, given its outstanding execution in the prior year.

While the second-quarter performance is likely to favour Woolworths, Macquarie does not believe this is an indication of the medium-term trend. The broker forecasts comparable store sales growth of 2% for both companies in FYI 18 and FY19.

Increased competition and the use of loyalty programs, with improved availability of stock, are expected to dampen margins over the first half. The broker expects first half earnings margins at Woolworths food and liquor will decline around 50 basis points to 5.0%. Margins at Coles are expected to decline 16 basis points to 5.1%. Macquarie maintains an Outperform rating for Wesfarmers, given the upgrades to its resources business in its first half guidance, with a Neutral rating for Woolworths.

Woolworths Petrol Divestments To BP

On December 28 Woolworths announced it would divest the 527 fuel convenience sites it owns and the 16 development sites to BP for $1.79bn. The transaction is subject to regulatory approvals and is not expected to be completed earlier than January 2018. The deal will still provide Woolworths with a fuel offer and the potential to expand its convenience offer through BP.

Woolworths will use the proceeds to reduce its bank debt and, using FY16 continued operations data, Citi calculates the deal will be 1% diluted to earnings per share. Woolworths has announced that as part of the transaction, it will pilot a “Metro at BP stores” format and, assuming the pilot is successful, roll out up to 200 stores under the format.

As Woolworths does not currently participate in wholesaling, Morgan Stanley suspects BP will require an alternative supply of food products. In this case, as Metcash ((MTS)) supplies a significant proportion of the food for BP sites the company is well placed to expand its business.

Morgan Stanley believes the divestment of the fuel business is rational and will alleviate balance-sheet stress. It should dilute earnings per share by 4-5% on a full year basis, on the broker's estimate that the business is sold for 10 times earnings (EBIT) and based on Woolworths part funding petrol discounts.

The broker is unconvinced about the proposal for up to 200 stores in the metro format, given the lack of historical evidence on execution. Petrol stations either tend to generate profit by petrol being sold at barely above cost to drive traffic amid profitable food sales or they sell petrol at a reasonable margin with negligible food sales. They don't do both, Morgan Stanley attests. The broker awaits clearance from the ACCC and FIRB on the divestments before including the proposed transaction in its forecast.

Morgan Stanley suspects Metcash will be the main winner from this petrol deal as it supplies the existing 1400 BP petrol stations and Woolworths does not wholesale. The broker estimates revenue uplift for Metcash could be around $400m which, at a conservative 3% margin, equates to $12m of EBIT, or a 3.8% uplift with very little incremental capital deployed.

There is one Buy rating on FNArena's database (Deutsche Bank), with two Hold and four Sell for Woolworths. The consensus target is $22.31, suggesting -8.5% downside to the last share price. Targets range from $19.10 (UBS) to $27.00 (Deutsche Bank).

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