Woolworth’s Premium Rating Under Question

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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 Chris Shaw

For some time Woolworths ((WOW)) has been held up as a prime example of a defensive play on the Australian market given the security of its earnings as its core products of food and liquor largely are non-discretionary items for households.

While such security of earnings can be an advantage for investors there is a corresponding disadvantage in the current environment in that the stock has been priced for perfection, consistently trading on an earnings multiple well above the market’s average. The price/earnings premium is further increased by Woolworths’ lack of competition – to wit, a struggling Coles ((WES)).

Such pricing for perfection means, as UBS points out, beating expectations is very difficult and falling short is much easier, meaning there is limited upside but the downside is unlimited. The group’s interim profit result last week is a perfect example as while the result itself was seen as a solid one, the stock dropped by around 7% as the market factored in the numbers.

Net profit after tax for the half rose 10% to $983 milion, Citi noting while the core divisions performed well the consumer electronics and New Zealand businesses disappointed and with costs increasing it leads the broker to suggest the company will likely only generate full year earnings growth at the lower end of the 9-12% increase indicated by guidance from management.

The other issue to arise out of the interim result according to Bank of America-Merrill Lynch is group cash flows, specifically as it relates to capital expenditure. Operating cash generation is not the issue as the results here were similar to last year but the broker points out free cash flow won’t cover dividends this year and are unlikely to next year as well, given capex should be around the $2 billion mark in both years.

In the broker’s view, this is a high level of capex given the current economic environment and the key going forward will be whether or not the company can generate an attractive enough rate of return on the money being invested. To date it suggests management has not done a particularly good job of addresing this question.

Offsetting this, the broker was very happy with the performance of the food and liquor operations and, as this remains the core earnings driver of the business, it summed the result up as the loss of some icing on what remains a very solid cake.

Macquarie agrees, taking the view the grocery and discount department store combination is simply too compelling a defensive option in the current economic environment as it should continue to deliver relative outperformance at a time when the broader retail sector remains under pressure.

Post the result, Bank of America-Merrill Lynch has trimmed its earnings estimates in for both FY09 and FY10 and is now forecasting earnings per share (EPS) of 147c this year and 163c next year, while Citi is slightly more conservative at 144c and 156c respectively. The FNArena database shows consensus EPS forecasts of 146.1c and 163.2c for FY09 and FY10.

While there were modest changes to earnings estimates across the market post the group’s interim profit, there have been no changes to ratings, the FNArena database showing a total of five Buys, one Accumulate and four Hold recommendations. UBS’s commentary indicated a downgrade to a Neutral view may have acompanied the result but the analysts suggest the 7% price fall post the result was an over-reaction and thus have retained a Buy rating.

The changes to earnings estimates mean the average price target according to the database is now $29.93, down from $30.56 previously. Bank of America-Merrill Lynch remains the leader with a target of $33.00, while Citi is the current low marker at $27.50.

Despite a very weak broader market ,shares in Woolworths today are slightly stronger and as at 12.20pm the stock was up 6c at $26.20, which compares to a trading range over the past year of $22.85 to $30.97.

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