Are bargains available at Woolworths?
On Wednesday November 2 Woolworths held a strategy briefing for professional investors. Woolworth’s effectively asked us to adopt a longer time frame before judging its performance and revealed four strategic priorities that I will describe in a moment.
Prior to the strategy day, the company updated the stock market with a growth outlook that was the lowest in a decade. The market responded negatively to the change and it entrenched previous sentiment by professional investors to switch from Woolworths to Coles.
But Woolworths remains a superior business from a business economics perspective, with high return on equity and it also remains cheaper than its competitor as measured by the larger discount to an estimate of its intrinsic value.
The wider sentiment towards Woolworths Supermarkets is that the period of strong growth is over, and the other businesses, such as Big W, the New Zealand supermarkets, the Masters hardware venture and a possible acquisition of The Warehouse group could be the focus of earnings growth for the company. Gambling pre-committments would not be.
Meanwhile, the Woolworths-owned Dick Smith electronics business appears to have failed to excite consumers and has certainly failed to excite investment professionals. Dick Smith is a relatively weak offering in a market that has been hit particularly hard by the empowerment of the consumer through high Australian dollar.
Moreover, in many ways these businesses are peripheral since the Australian Food & Liquor division accounts for 80% of earnings before interest and tax.
The impact of the company’s lower growth profile on intrinsic value, particularly intrinsic values over the next two years, has been negative and intrinsic value does not appear to be going anywhere in a great hurry (see Skaffold chart below).
This combination of circumstances, in my experience, set Woolworths shares up to be vulnerable to any negative shocks.
Estimating intrinsic value is not the same as predicting price direction, however the above circumstances are not unique historically in putting a lead on price appreciation.
On top of the above combination of factors, there is also the continuing debate in Parliament about the introduction of preset loss limits for poker machines, which, if introduced, would negatively impact Woolworths’ gaming business. Though it is most closely associated with supermarkets, Woolworths is actually the largest poker machine owner in the country, with more than 10,700 pokies.
And a few weeks ago, The Economic Times of India also reported that Woolworths appears to have been dumped by its Indian partner, Tata Group. Woolworths enjoyed a five-year partnership with Tata, introducing Dick Smith-style electronics stores to India under the Infiniti Retail brand. Even though foreign retailers are not permitted to have a direct presence in India, Woolworths partnership offered the hope of growth – albeit with a partner – if the rules were ever relaxed.
Nonetheless, despite these accumulative negative factors, Woolworths is regarded by conventional analysts and investors as a defensive’ company. Its strong cash flows and its status as a major retailer of food makes it an ideal investment in a recessionary or slow or low growth environment. The company also enjoys entrenched competitive advantages over smaller rivals that, until now, the ACCC has done little about. One example of this are the new EFTPOS charges.
From the first of this month, the new Eftpos Payments Australia Limited (EPAL) fees mean retailers incur a 5¢ fee for every transaction over $15 (75% of all EFTPOS transactions). Previously there was no fee and that will still be the case for transactions under $15, which means 25% of transactions.
The retailer’s bank will charge the retailers, some of whom are describing the charges as an “EFTPOS tax”, and they will have no choice but to pass on to the consumer.
Unsurprisingly, EPAL’s members include the major banks, Coles and Woolworths and, because they manage their own terminals, they can opt out of the new charges.
But despite these entrenched advantages, Woolworths has been hit – or so it says – by the state of the economy, noting in its annual report: “Consumer confidence remained historically low as customers reacted adversely to rising utility costs, interest rate hikes in the first half of the year and general global uncertainty, and opted to save rather than spend their money”.
From an investment perspective it is worth noting that retail investors now have a choice of supermarkets, with Coles improving its offering to consumers and taking market share from the incumbent Woolworths.
The investment community is not convinced that further changes to private-label offerings or more innovation around the supply chain will make a dramatic difference to the growth prospects for Woolworths, which set below forecast growth in household income, population and the economy.
One other source of earnings growth is cost-cutting, but the reality is that gains from such strategies are one-offs and again unlikely to excite investors.
Having presented the negatives – which have caused the share price to fall 12% since July, one positive was the strategy briefing’s opportunity to showcase new CEO Grant O’Brien, who replaces Michael Luscombe. The company announced that it planned to extend and defend its leadership in food and liquor, act on the “portfolio” to maximise shareholder value, maintain its track record of building new growth businesses (we’ll ignore Dick Smith) and finally, put in place the enablers for a new era of growth.
In the supermarkets business WOW hopes to grow fresh produce from 28% market share to 36% market share. If achieved this would be an additional $2.5b in sales. Woolies also wants to target a doubling of home brand sales and this aim flies in the face of the ACCC’s stated concerns.
The company will also open 35 new BIG W stores in next 5 years reaching 200 by 2016.
In a reflection of the massive structural shift online, BIG W’s 85,000 in-store SKUs will be expanded and all put online.
And the topic on the tip of everyone’s tongue; Masters. There are now five stores open, another two are due to open in December/January, there are 16 under construction another 100 in the pipeline and the company reported the venture is well ahead of budget.
I also note the advertised sale of $900 million of property ($380 million of which was sold last financial year); and, most recently, the oversubscribed $500 million hybrid note raising that substantially extend the balance sheet strength of the company.
Below we examine the intrinsic value track record and prospects for Woolworths based on current expectations for earnings growth and returns on equity using Skaffold.com
Woolworths (MQR: B2) is currently trading at the same price it was in December 2006 and February 2007, despite the fact profits have risen 11.1% pa, from $1.3 billion to a forecast $2.2 billion in 2012. This growth in profit however is offset by having 16 million more shares on issue; by increased borrowings – up $1.8 billion to $4.8 billion; and by retained earnings, which have risen by $2 billion. The increase in shares on issue and retained earnings have offset the positive impact on return on equity rising profit would normally have.
The latest estimate of its intrinsic value, of $23.23, is forecast to rise modestly over the next two years. For investors looking at opportunities to investigate only when a meaningful discount to intrinsic value is presented, a price of $19 or less for Woolworths would represent at least 20 per cent.
Posted by Roger Montgomery, Value.able author and Fund Manager, 17 November 2011.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Andrew
:
Probably be a bit late to really add anything to this discussion but as what has probably been evident in a post i sent a while a go i am becoming a bit dissapointed in WOW.
I have recently moved from the south west of Sydney to the Northern Beaches and i have noticed a big change in the competitive landscape there.
My wife and I have walked into Woolworths and not been able to find what we want whilst we have found everything we want in Coles, and coles is as busy if not busier than woolworths which was nowhere near the case in my previous area. I would like to see the market share Woolworths and coles have in these areas to see if my observations ring true.
Coles i think is now offering quite a capable challenge to Woolworths. The momentum is with them, it will be interesting to see what Woolies can do to try and stop that.
I like the cost focus WOW has, i can see exactly why they give customers a choice as to whether they want a receipt for purchases below $20 as this would help cut costs but i can’t help but think in terms of range and convenience it is easier to go to coles.
Roger Montgomery
:
Thanks for the scuttlebutt Andrew.
Ann
:
Woolworths has its challenges, long periods of social culture there are taking its toll…
Bruce
:
Hi Roger
A little off post, but have just signed up to Skaffold and run my portfolio through some testing, am getting rid of one stock but will be keeping WOW because I bought at a much lower price than present.
Congratulations on a great, easy to use product.
Regards Bruce
Roger Montgomery
:
Thanks Bruce, I will have the Skaffold Team respond to your other query.
John C
:
Hi Bruce, Roger. I also have found Skaffold useful to do some weeding in my portfolio. I’ve sold APA (last week) at a healthy profit, due to their low quality/performace rating, low IV, high debt, and low future prospects (and high share price relative to IV and also relative to what I paid for them 3 years ago). I bought Seymour White (SWL) instead, and it’s been heading northwards nicely since (not that short term SP movement matters, but’s it’s still nice, when the banks and resources are heading south)…
Skaffold isn’t the only tool in the shed, but it’s by far the most powerful and versatile in my experience.
Roger Montgomery
:
Thank you John, coming from you, that’s particularly appreciated.
joe
:
Hi Roger
I hold fge shares and at there agm the ceo said they had 500 mil plus of revenue booked in for 2012 year up 80mil over previous year . monodelphous have 870 mil booked in for this year at the moment down from last year Yet mnd are 4 times the price of fge . can you tell me is mnd dear or fge cheap. and why have mnd have 14broker coverage dcg has7, cdd7 mce4 and fge only 2 is this the reason for lack of interest in fge and is it up to the ceo to do more PR work
thank you
Roger Montgomery
:
Hi Joe,
It doesn’t sound like Forge’s CEO needs to do more work! It sounds like the analysts need to do more. The reason for the difference in coverage is due partly to market capitalisation (FGE $385 million, MND $1.7 bln) and partly to the much longer period MND has been listed. WIth each company issuing approximately 85 million shares (MND 87 and FGE 83) and the P/E of FGE about 10 and the P/E of MND about 18 it certainly seems there’s room for the spread to narrow. If you look at price/sales the argument is more compelling. Of course this is not a recommendation and you must seek and take personal professional advice.
John C
:
I hold MND for the yield, and FGE for the future capital gain. The less analysts cover stocks, the more chance that those stocks will be unappreciated and underpriced, in my experience. Once a stock makes it into a major index, the chances of coverage and associated price appreciation increases, but that’s only useful if you already hold the stock. Our job then is to pick the best quality, under-analysed, and under-priced small-caps with the brightest prospects, then stick with them, unless the fundamentals change. In the case of MCE, I suspect that may be the case. In the case of FGE, it hasn’t, and I continue to hold.
In my opinion, it’s the CEO’s job to manage the company well, not to sell the company to analysts and future shareholders. Roger’s recent Eureka report article on Embleton (EMB) is an example of a company with excellent management, who just do their job well, with no hype.
Greg
:
I regard Woolworths as a mature company. Woolies growth should be low, not 20% per annum. Woolies is attempting to retain their high growth by entering markets such as fuel, pharmacy, hardware, home brands and probably some I have forgotten. Instead of robbing Peter to pay Paul why don’t they lift their dividend rate and accept lower growth.
Perhaps it has something to do with remuneration packages. Should remuneration be based on keeping a steady ship instead of endless growth.
Dr David Suzuki, Dick Smith and others are denouncing the pursuit of endless growth. A good place to start with changing our mindset might be remuneration packages.
Roger Montgomery
:
Interesting book I am reading on that subject at the moment by Ha-Joon Chang, 23 Things They Don’t Tell You About Capitalism. SOme of the arguments are tenuous but others are very convincing.
Peter
:
Roger,
I am stuggling with the quality score comparison in Skaffold of WOW ( B ) and WES ( A ) whilst on all financial metrics it would appear WOW is the superior business?
Can you help with more information that makes up the quality score?
Peter
Roger Montgomery
:
Hi Peter,
Sure, thats an easy one! Give the Skaffold Team a call at the office and they’ll put you through to me.
Gale
:
Roger
Thanks for this – thought provoking as usual.
One of those thoughts was to wonder whether it had occurred to our political masters to try to barter access to the Indian market for Australian retailers in return for uranium sales! (Sorry if that is too political to make the cut)
Another thought is that, even if Woolworths profits and share price are likely to be flatter in the short or medium term, their new hybrid notes are attractive (especially to the aged, such as me) as a comparatively safe earnings stream.
Regards
Gale
Peter
:
Gale,
A couple of the banks have hybrids which pay higher return than the WOW notes and with less risk.
Peter
Ash Little
:
Hi Peter why do you say less risk.
If things turn ugly… I am not saying it will….surely WOW will make the payments but if the banks make losses then these hybrid will have no yeild.
Hi Risk in Bank Prefs in my view………Recession equals losses equals zero payments for hybrids in my view.
WOW is way lower risk.
Our banks have not made losses for 20 years but I know for certain that they will at some time in the future…….Nothing is more sure…………I just can’t tell you when
Paul Kloeden
:
I note that intrinsic value is, according to Skaffold, due to increase at 11.4%pa. You refer to this as modest, and elsewhere suggest iv is not “going anywhere in a great hurry”. I would have thought that this, while perhaps not spectacular, is not too bad for conservative investors.
If we assume that, in the weighing machine long run, the price of the business will reflect the increasing iv, and add to this the dividend of 6.9%pa (with franking credits), then the business could provide an investor with an annual return of 18.3%. Within the context of a super fund, I am happy with that sort of return.
Roger Montgomery
:
Great stuff Paul. I could have said IV not going anywhere in a great hurry relative to the share price currently but the comment is in the context of expected declines in future intrinsic values following the downgraded growth announcements the company has made. Hope that helps.
If the valuations aren’t lowered as a result of downgraded expectations then 11.4% is great – especially if you can also get a big discount to intrinsic value.
Roger Montgomery
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Just another quick thought that was inspired by your observations Paul,
Everyone will have a different investment process and for some, as you correctly point out, an 11.4% increase in intrinsic value is adequate. For others it may only be adequate for ‘big caps’ and still, for others, it may not be nearly enough. The great thing is it is now easy to search +2000 companies for those whose intrinsic value is estimated to be rising by this amount. And its equally easy to find those companies that have, for example, estimated intrinsic value growth of 12% or more and whose shares are trading at more than a, say, 20 per cent discount to the current year’s estimated intrinsic value.
Dazza
:
Hi Roger
I just joined up to skaffold today and you’re right it easy as to do just that – i assume you meant skaffold provides you an easy way to search companies for whose intrinsic value is estimated to be rising by xx%. The table view allows you to do that and more, you can filter by Quality (eg just A1 & A2) and i really like the industry sector and group break up that contains a hierachy (i.e subgroups)…nice :). i’m a kid in a candy store and I love it!!
Keep up the good work.
Dazza
Roger Montgomery
:
Thanks Dazza,
I have taken your suggestion for an improvement offline because I don’t want a competitor to benefit!!!! We already had that idea planned for development.