Looking Behind The WOW Factor

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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

By Greg Peel

As a listed consumer staple stock Woolworths ((WOW)) has proven an enigma over a number of years now – as far as Stock Analysis 101 might dictate – given its persistently high earnings multiple and persistently high premium valuation to its retailing peers. Never has an ASX ticker code been more apt, as Woolies has moved from quarter to quarter simply wowing all and sundry with its sales growth during both good times and bad.

A lot of Woolies’ success has been as a result of the demise of once equivalent rival Coles, now part of Wesfarmers ((WES)). Coles proved that if you take your eye off the ball just for a moment in a government-sanctioned duopoly, it’s a slippery slope to oblivion. The other duopoly member can simply feed off your failure like a parasitic twin. Hence Woolies has been able to defy all expectation, particularly in the staple game of Food & Liquor, by continuing to post record breaking sales and continuing to attract investor support even though valuation multiples are flashing a big Sell sign.

What multiple should Woolies trade at? It has now maintained a multiple in the twenties for years.

There has been one broker who has argued that Woolies valuation is too high for nigh on two years now. Macquarie downgraded the stock to Underperform in July 2006 when the share price hit $20, and it has since risen steadily to a peak of $35 in December last. That it is now at only $29 is a reflection of the broad market, credit crunch related pullback, and not of a wavering multiple.

For every other broker in the FNArena database, it’s been a case of once bitten twice shy from putting a Sell on Australia’s greatest retail success story. But they’re just never bashful at The Factory. The most other brokers are prepared to retreat to is Hold, which implies a market-weight position. The current B/H/S ratio in the database is 6/3/1, which means three brokers believe Woolies should only be in one’s portfolio on its sector weighting. The other six are happy to Overweight a stock that supposedly trades at a multiple that it shouldn’t trade at.

But it is not just the high multiple that keeps the Hold raters wary. And yesterday’s third quarter sales result is a case in point. While Woolies may sell milk, bread and other staples which defy any economic downturn, cash-strapped consumers are still going to start steering away from the $7 Jarlsberg cheese and the $20 Penfolds red in favour of the home brand and the clean skin. Less money will also be spent at Big W – a slightly ritzier K-Mart.

Thus it was yet another surprise that Woolies pulled off yet another better-than-trend sales result. All economic indicators are flashing warning signs of a fall in consumer spending. But the reality is that when you look more closely at the numbers, particularly the Food & Liquor numbers, one factor hits you in the face.

On a dollar basis, Woolies F&L sales increased 6.7% in the quarter compared to 6.0% in the previous quarter (adjusted for Easter). However on a volume basis, sales growth was only 2.2% in Q3 compared to 5.9% in Q1 and 6.0% in Q407. The difference was 4.5% of inflation.

Many analysts, some of whom even do their own supermarket shopping, were taken aback by this inflation increase. The RBA can fiddle with the numbers all it wants but when you have to take out a mortgage to buy a lamb roast, and sell one of your children so you can have parsnips with it, the reality is food has become alarming expensive in Australia. And yet we produce nearly all of it ourselves (even the Jarlsberg cheese).

So throw in high interest rates along with high food and petrol prices and one has to expect Woolies is going to really struggle to show anymore striking results from here into the next couple of quarters. Add in the high peer premium and you can see why at least three brokers are saying Hold only.

Yet with all that going on, six – count them, six – brokers still say Woolies should be overweighted. How can that be?

Well for one thing, on a broader scale Woolies is a cashflow business. At any time of economic weakness cash is king, and never is that more emphatic than in a credit crunch. On that basis, and Woolies’ simple consumer staple status, the company should be overweighted against other more cyclical or debt-ridden sectors.

But from within the sector, Woolies is still trading at this ridiculously high multiple. Justification here comes straight from the duopoly. There are a couple of pretenders about, but realistically the whole Australian supermarket space is dominated by Woolies and Coles. Coles is still a train wreck, and it’s going to take Wesfarmers a lot of time, money and effort to pick up the locomotive and the carriages and get them back on track. Then it has to come up with a way of attracting back all those lost souls who have since migrated to Woolies.

In the meantime, Woolies has been turning the knife. So flush with cash is the company that it has embarked on a program to ensure that what seems like a duopoly will remain realistically a monopoly for years to come. Woolies has taken the opportunity to transform its stores into a twenty-first century shopping experience that will supposedly have shoppers falling over themselves to get in the door. Not only does Coles have to get itself back up and running, it has to go that extra yard and match Woolies improvements before it can even begin to compete.

This is the major factor in those six brokers’ Buy ratings. Sure – Woolies will see a cyclical drop in volumes, but it will emerge at the other end so strong that future revenues are all but assured.

The average target price on Woolies is $32.64. That’s still 12% above the last traded price despite its multiple reflecting a 25% premium over the ASX 100 (ex banks) and a 50% premium to the equivalent ASX 300.

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