Brokers Question Big W’s Future

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This story features WOOLWORTHS GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: WOW
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

Woolworths reported solid March quarter sales of food but another disappointing downgrade for Big W has broker views diverging on the implications for the outlook.

-Risk to margins still high as a competitive environment intensifies
-Is the turnaround in food momentum factored into the current share price?
-Questions mount over the profitability and viability of Big W
 

By Eva Brocklehurst

The Australian food business of Woolworths ((WOW)) has built a head of steam, with sales up 5.6% in the March quarter, adjusted for Easter, or up 4.5% on a like-for-like basis. New Zealand supermarkets also improved in terms of sales momentum, while liquor, hotels and Big W were in line with the first half.

Morgans believes the company has gained market share from Coles ((WES)), Metcash ((MTS)) or Aldi in the quarter. Woolworths also reported price deflation of -2.5% versus Coles at -0.5%. This highlights the price investment that Woolworths is delivering to the business, although the broker suspects this will come at a cost to margins.

Margin Versus Sales Improvement

Despite the turnaround strategy gaining further momentum, Morgans believes the outlook is well and truly factored into the current share price while, longer term, the risk to margins is high as the competitive environment intensifies. UBS is more positive in its view, believing momentum is likely to continue, as execution is improving and this should mean the company narrows the gap further to Coles across key metrics.

The broker concedes there is a long way to go in the turnaround but from a value perspective, believes the market is under-estimating the upside and ascribing an undemanding -10% discount to the stock versus the ASX 200. Continued execution on the company's plans will, in the broker's opinion, mean this discount contracts. The main risk is envisaged to be an irrational competitive response.

Citi also does not believe the sales improvement is coming at the expense of margins, which are expected to expand in the second half. The broker forecasts a 53 basis points increase in food margins in the second half, with the largest positive contributors being reduced inventory losses, better buying terms and operating leverage.

This, admittedly, is being offset by price investment, a re-setting of depreciation and staff bonuses but Citi expects margins will surpass Coles in the second half. The broker maintains a long-term forecast that Woolworths margins return to 5.5%, versus Coles at 4.9%.

Macquarie observes the performance of the food business demonstrates the benefits of the company's heavy investment in price and improved store execution over the last 18 months. The rate of sales growth should benefit margins and the broker maintains a 30 basis points forecast for expansion in operating earnings (EBITDA) margins the second half. This reflects some conflicting forces, the broker acknowledges, such as unplanned cost increases, which counter the benefits of operating leverage.

Nevertheless, the stock is suspected of pricing in an aspirational earnings recovery in Australian food, which Macquarie believes is increasingly unlikely in a competitive environment. Hence, a downgrade to Underperform.

Morgan Stanley is also mindful of the difficult balancing act in terms of sales versus margin and believes the stock's rich valuation reflects expectations of an earnings recovery that is too steep, and bulls are too optimistic about the level of margin expansion the company can achieve.

Big W

The company has warned that the second half loss at Big W is now likely to be $115-135m. A turnaround is still a long way off, Morgans asserts. Easter adjusted sales fell -6.1% or -5.7% on a like-for-like basis. The chain is expected to be loss-making in FY17 and, while turnaround strategy is in place, the company provided few details.

Morgans does not expect Big W to return to profitability until FY21. Citi agrees the turnaround will take time and the losses reflect the challenging operating environment in the discount department store category. After six years of negative like-for-like sales growth the broker does not expect a return to positive until the first half of FY19.

Macquarie believes comparable sales growth for Big W is not disastrous, versus peer performances in the current quarter, although acknowledges this is the eighth consecutive negative comparable third quarter in a row. The broker believes both Big W and Wesfarmers' Target need to validate their economic viability over the next 12 months.

The company's warning on Big W for the second time in four months leads Morgan Stanley to question whether this business is a liability, given its significant long-dated leases. The broker suspects the company has little idea how to handle Amazon entering the Australian market and appears to lack confidence in a swift improvement. Hence, Big W could prove to be a distraction for management and a drag to earnings.

Credit Suisse also believes Big W will be hard to fix and creates a large downside risk as well as, potentially, a billion-dollar closure. The broker believes the flexibility to address the underperformance in Big W hinges largely on the ACCC approving the sale of fuel, which will not be known until July.

The broker notes the company declined to discuss its plans for Big W and the revised loss appears to include another large impact from clearances. Whether there is room for three discount department stores in the Australian market is debatable, in the broker's assessment, and profit histories suggest not. On balance, Credit Suisse also finds the stock expensive.

Deutsche Bank also finds management's reticence regarding its plans for Big W provide little confidence in a turnaround. Nevertheless, the broker is increasingly comfortable with the momentum behind the food business and retains a Buy rating.

There are three Buy ratings on FNArena's database, one Hold and four Sell. The consensus target is $26.56, signalling -1.6% downside to the last share price. Targets range from $22.00 (Morgan Stanley) to $30.00 (Ord Minnett).
 

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