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Should we write off Woolworths and buy Wesfarmers?

Should we write off Woolworths and buy Wesfarmers?

Woolworths reported its first half 2010 results in recent weeks and the 17 per cent decline in the share price ahead of the result suggested investors may have been betting that the company was giving up ground to a revitalised Coles story. The price of Wesfarmers shares – being almost double their intrinsic value – certainly suggests enthusiasm for the latter company’s story.

Studying the results and the company however suggests any pessimism is unfounded and premature.

When I study JBH’s results there’s evidence of a classic profit loop. Cut prices to the customer, generate more sales, invest in systems and take advantage of greater buying power, invest savings in lower prices and do it again. Entrench the competitive advantage.

It would be obvious to expect Woolworths, with its history of management ties to Wal-Mart (who also engages the profit-loop) to be producing the same story, however WOW is flagging an arguably stronger position.

Where JBH’s gross profit margin keeps declining and net profit margin rising, Woolworths’ gross margin has increased every year since 2005. Revenues were 4.2% higher and gross profits rose by 6.5% in the latest half year result. Like JBH, WOW’s EBIT growth was stronger at 11%. As analysts we are mystified as to what is driving the increase in gross profit margins but standing back, you realise its a really good thing; if analysts cannot work it out then perhaps neither can the competitors and that’s good for maintaining a competitive advantage.  Competitors cannot replicate something if they don’t know how its produced.

Woolworths competitive advantage – an important driver of sustainably high rates of return on equity (I expect them to average 27% for the next three years – subject to change of course at any time and without warning or notification afterwards) – is its scale and its total dominance, ownership of and class leadership in supply-chain management.  The result is that a small increase in revenue even if due to inflation, results in a leveraged impact on profits.

From a cash flow perspective the other fascinating thing is the negative working capital. To those new to investing, working capital is typically an investment for a company; a business orders its products from a supplier, pays on 30 days terms and then spends the next few months selling the product it sells. If its takes a long time to sell the product and the customer takes time to pay, then there is an adverse impact on cash flow because the business is forking out cash today and not getting paid for some weeks or months.

In Woolworths case, as you might expect, the company is so strong and its buying power so dominant that it can dictate terms to its suppliers, making sure they deliver the right quantities at the right time. It can pay them when it likes and perhaps even pay them AFTER it sells the goods to consumers who buy with a debit, cash or credit card, which means Woolworths gets its money from its sales activity immediately. The difference of course can be invested.This virtuous cycle is highlighted by a negative number for working capital (WC = Inventory – Trade Payables + receivables – other creditors) which in Woolworth’s case, got even more negative! Don’t go rushing out and buying the shares because of this fact – its well known to the market and suppliers (who no doubt resent the company’s powerful market position). In the latest result, it was also attributable to timing differences in creditor payments.

The steep decline in the share price ahead of the company’s first half results suggests that many investors and analysts may have considered the company “ex-growth” and favoured Wesfarmers. Given the relative performances and valuations, this is likely to prove to be a mistake (more about that in a moment).

The company still has a lot of room to substantially increase sales and profits and the disbelief in this regard reminds me of the decade after decade in which analysts said Coca-Cola couldn’t grow anymore.

It would take a very almost illegally-informed and dedicated analyst to reach the conclusion that the company cannot continue to enlarge its coffers from further improvements to its overseas buying capability, its private label sales (both admittedly to the detriment of many smaller local owners of branded products) or its supply chain management. There’s also growth from acquisitions (speculative and don’t ever base a purchase on it), the Everyday Rewards loyalty card program and the hardware rollout (it will interesting to find out what they think their USP is).

While it will be interesting to find out what has been driving the competitor Wesfarmers sales numbers (basket size of more customers), the fact remains that it is premature to write off Woolworths. Many analysts will also be concerned about retailers cycling (comparing sales and profits to previous results) the fiscal stimulus, this is simply a short-term distraction and does not have anything to do with the long-term value of the company.

On that front, my calculated intrinsic value for Woolworths has risen every year for the last decade. When Buffett says he’s looking for companies with a “demonstrated track record of earnings power”, its because it translates to rising valuations. Woolworths was worth $2.39 in 2000. Intrinsic value rose to $14.84 in 2005 and $25.70 in 2009. Today’s value of $25.80 is expected to rise to $28.00 in 2011 and almost $30 in 2012.

The current price of $28.05 is therefore now equivalent to the valuation 15 months out and the February low prices are perhaps a better reflection of the current valuation that I have.

I have rarely been able to buy Woolworths at any significant discount to intrinsic value in the last decade and while I don’t know what the price will do next, I do know that irrespective of whether Woolworths offers lower prices in the supermarket or the share market, you would be ill advised to ignore them.

Please be reminded that my valuations for the future are based on analyst expectations, which can change at any time.

Posted by Roger Montgomery, 8 March 2010.


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.

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  1. David Harms

    I note your suggestion to look at DWS. I have invested in ASG group (code ASZ) They are in a similar space and have done well and have been growing consistently the last 5 years. I would be interested in your comparison of DWS and ASZ. In the business I am in, our expenditure on IT is still rapidly increasing and we are becoming increasingly reliant on these types of service providers. I think they certainly have plenty of scope to grow if they can maintain advantage over competitors.

    • Hi David,

      Rather than me offering a view, can you expand on your experiences with these service providers and perhaps explain how they help your business and where they fit in on your growth path?

  2. Just comparing your val of 25.80 to another value I have seen which is running around 33.00.

    Wondering what was significantly different to produce varying valuations?


    • Hi Scotty,

      I have no links to any other valuations so I can’t comment on the differences. I do all of my own work and have no need for anything else. I cannot tell you what anyone else has or why they have it. Like many value investors, I am not interested in relative performance only absolute performance. I have employed all the faculties of my mind overtime, then crossed checked my results with peers in whom I have the most respect and found that a wayward youth – in terms of understanding how to value a company – has given way to a more refined and sensible approach. Its discussed in the book.

  3. Hi Roger-

    Reading your posts you probably would agree with me that the market does not offer any real value.Do you short stocks that are overvalued?


    • Hi Nick,

      You can but the risks are asymmetric. When you buy a share can only go to zero. When you short sell, the share can move infinitely higher and so the risk has no limit. Remember that valuations are not a prediction about where the price will go, although on that count the model has worked pretty well.

  4. An excellent column Roger.

    I like your investment philosophy very much, wonderful businesses with great prospects selling significantly below your own calculation of their intrinsic value, however I wonder if this philosophy comes unstuck with businesses of the caliber of Woolworths, CSL and Cochlear?

    You said yourself towards the end of your article “I have rarely been able to buy Woolworths at any significant discount to intrinsic value in the last decade” and I wonder if you would consider modifying your investment strategy slightly for such top businesses as WOW, CSL and COH where instead of waiting for a significant discount you would instead only wait for a discount??

    I purchased WOW and CSL recently and have watched them appreciate considerably since and am waiting patiently to buy a few shares in Cochlear although I do not expect to buy them at a significant discount to my own intrinsic valuation simply because they are such a good business.

    Please don’t mistake my suggestions for arrogance, I have a great respect for your thoughts despite our differing opinion on Wesfarmers, hahahaha.

    Best wishes to you.

    • Hi Nick,

      The dilemma you describe is one of the reasons I look at changes to the future valuation. Smaller positions however are called for. I too own CSL in my portfolio – which I write about in Alan Kohler’s Eureka Report. There is no modification of the investment strategy. One simply must decide how long they are prepared to wait for intrinsic value to catch up. You may not buy at a discount to this years value (although that is by far the most preferable), you may buy at a discount to next year’s value. You better hope however that your analysis of future earnings and profitability are right.

      • I have pondered that issue a fair bit as as well. I like the way you put that Roger, makes a lot of sense.

        Love the blog, thanks for taking the time that you do.

      • Hi Roger,

        Thanks for an educational and thought provoking blog.

        My question applies to selling quality businesses like WOW, CSL and COH. I used to believe in a buy and hold forever approach but can see the sense in selling when Mr. Market is in one of his manic moods. You have said that one of your selling criteria is when price far exceeds value. Would you require a greater premium to value before selling such quality businesses (whose value you foresee to keep rising)? My selling benchmark for these sort of stocks is 50% overvalued whereas I would sell lesser quality businesses at a smaller premium. I would imagine that this would be influenced by your calculation of intrinsic value into the future. I appreciate your feedback. Thankyou

      • Hi Tim,

        I have discovered its simplistic to set a defined percentage. Its better to look at the time it will take before value catches up to the price. Using ‘time’ you can better determine the opportunity cost. I hope that helps.

      • Hi Roger,
        Yeah that does clarify things – thanx. It seems to me that sustainability of returns is important to judge, not only as an indicator of business quality but also as a guide to when to sell.


    • Hi David,

      I have received a small mountain of valuation requests. I am collating them all and gradually I will post my results here on the blog. I have to deal with those for which I have received multiple request, first. Thanks for yoru patience.

  6. Roger I have heard about 2 LIC’s Argo and AFI, what do you know about them. Are they worthwhile

    • Hi Barry,

      I was a fund manager for years and founded and listed an investment company myself so I know ARGO and AFIC very well. You will basically receive index exposure and can at least improve the yield you receive if you buy at a discount to NTA. That of course does not represent advice. Make you you get some from an adviser familiar with your needs and circumstances before transacting.

  7. I am interested in your thoughts on Metcash Trading. They have supply agreements with the final fifth of the national supermarket space but do not necessarily own all those other shops or even operate them. Not for a moment would I consider Woolworths to be anything but the superior prospect – however, price is important and I wonder how your calculation of Metcash’s present intrinsic value compares to its current price and future valuation?

    • Hi John,

      I like to buy the leader. Market share for Metcash however is pretty impressive. I will have to have a look at ROE and debt levels. John, you have been around here now for a while, do you want to supply a few stats? I need, for a few years, ROE, Equity, EPS, DPS, Debt, Cash flow from operations and cash flow from investing activities.

      • Sure. I use Metcash’s year-ended annual reports for 2006 to 2009. Note that a reverse-acquisition happened between 05 and 06, so the 2005 figures in the 2006 report were restated. I couldn’t get my head around the accounting changes so I left 2005 out (and the poor quality scans were made for hard reading).
        Also note that 2007 distribution and admin costs were re-adjusted in the 2008 report so I used the latter’s 2007 figures instead.

        ROE: 7.86, 14.3, 15.9, 15.9
        Equity (mil): 1,032.9, 1,163.0, 1,239.7, 1,277.4
        EPS (diluted, cents): 13.52, 20.9, 25.74, 26.45
        DPS (cents): 11.5, 17.0, 21.0, 24.0
        Long-term debt (mil): 751.3, 605.7, 610.6, 638.2
        Cash flow from operations (mil): 242.7, 177.5, 197.5, 248.1
        Cash flow from investing (mil): -149.2, -58, -12, -106.2

        A shame that the high ROE is going to waste with a high payout ratio. Let me know if you’d like more info.

      • Hi John,

        2005 was a difficult year for many analysts because of the move to IFRS (“IF-Ress”). Just looking at the numbers, my back of the envelope says the intrinsic value is about $2.30

  8. H Roger,
    I just read two of the books you recommended one by Chris Browne and the other by Bruce Greenwald.
    Loved the logic in the Greenwald book, particularly the idea of basing a valuation on something that can be valued reasonably accurately ie something not too far into the future.
    The asset value and earning power value seemed to make a lot of sense to me.
    just ran WOW through the calculations. the assets are about $8 and the earnings power value based an the cost of capital ie the 10 year bond rate of 5.32% is about $28
    Isn’t it interesting how there is such a big gap between asset values and the earnings power valuation?
    It would appear that the management and competitive advantage are well and truly included in intrinsic value.
    Don’t know if you are using something similar to Greenwald’s calculation but it seems to be more reliable than the McNiven ROE model

    • I am glad you enjoyed the books. I enjoyed Greenwald’s as well. The Columbia Business School teaches Greenwald’s valuation continuum approach which has some curiosities. For example, I think it is worth questioning the idea of starting with Graham’s Net-nets as the base of the continuum, but then attempt to come up with a value for brand/business by using a multiple of expenses. Even a dud business receives this valuation multiple. Its got me thinking… Leave it with me. Some very interesting oddities indeed.

  9. Greetings Roger, Competition seems an important contributing factor in WOW. Aldi is making heavy in-roads into the Western District of Victoria. Seemingly each city with population above 10000. If this is replicated throughout Australia, surely this has the greatest potential to squash projected growth targets in WOW. It appears to me that the diversification of anxiliary areas in the major competitors will dictate success in the future. By this, I refer to the hardware/garden items. I’m intrigued as to how growths may be forecast with such an unknown quickly magnifying. I enjoy your pertinent commments which seem to ruffle a few so-called experts, at least that’s my impression watching their faces on the TV. Cheers, John.

    • Hi John,

      It is not my intention to ruffle any feathers. The young ones do think the low valuations are a little odd, but that shouldn’t dissuade you. You aren’t wrong because everyone disagrees with you. I hear what you are saying about Aldi, but looking at market share, they are some way off having the leverage Woolies can produce when it makes incremental improvements.

  10. G’Day Roger,
    Thanks for making yourself so accessible.
    Woolworths share buy back , does this indicate they think that growth is not there at value and this is the best use of excess funds to increase share holder value? Is this a weakness?

    • Hi David,

      A $400 million buyback for a $32 billion dollar company seems pretty insignificant. Perhaps they think the shares are at or below intrinsic value. Its is usually the case that if sensible management cannot find sensibly priced acquisitions and if their own shares are cheap, then sometimes the best acquisition is yourself.

  11. Hi Roger

    I note that the retiring CEO of JBH has sold half of his JBH shares. I recall your concerns re the recent sale by the CEO/ founder of MMS. What are you thoughts on the JBH sale.



  12. Steve Moriarty

    Hi Roger,

    I know over at Eureka Report, your colleague Alan Kohler raised the issue of Costco’s arrival. I wondered if you had any thought about that and the potential on WOW.

    I also noted that JBH and WOW were in direct competition to each other in the hi-fi field as I seem to remember that Wollies were seeking to gain more of this market. I assume that one of them will suffer s a result?


    • Hi Steve,

      One of the great things about studying businesses is that they never stand still. Time will of course be the arbiter of who succeeds but JBH’s threats are not from Woolworths. I wrote about Costco in the Eureka Report quite some time back. I have been to the Melbourne store and thanks to a friendship in the US, was permitted to take my mother through without waiting for an hour to become a member in Australia. I have also visited several stores in the US. What you notice there is that Costco co-exists with competitors. It will co-exist here to. There will be marginal changes to competitive positions for many and dramatic changes for some, you will find the larger players will be less affected in the short and medium term.

  13. Hi Roger,

    Great read as usual.

    Most people keep telling me that I should’ve bought Wesfarmers, but like you say, own the dominant player… I was waiting a long time to pick up Woolies for the right price (got most of them between $25 & $26).

    Just a couple of quick questions (if you have time), what did you make of the announcement of the share buy-back? Surely it’s a good thing for next years ROE (and the possibility of more in the future)?

    And also Woolies entering the hardware market. With the Woolies loyalty cards & cross-brand promotions etc, surely this will be a winner in the long run? I’m no business genious, but there seems to be alot of potential there.

    • Hi Shaun,

      See my earlier comments here about the buyback. Regarding the other opportunities; they are a great potential source of ensuring a sustainably high ROE.

  14. Hi Roger

    Given the much talked about population growth in Australia wouldn’t the future growth prospects of Woolworths be tied to that and considered almost a certainty ?
    Of course there is a risk they could be trumped by a competitor however this seems unlikely with managements track record to date.

    • Hi Peter,

      You’re right. If the relative market shares stay the same, then the competitors all benefit in proportion.

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