FWIW Morningstar published their updated views on WOW overnight - they have it as a 2 Star stock with a Fair Value of $27.50
Woolworths: Hard to Find the Silver Lining in a Tough Quarter
Analyst Note | by Johannes Faul Updated May 02, 2024
Woolworths' March quarter 2024 update reveals that, like competitor no-moat Coles, its customers are under pressure. Australian supermarket sales grew a modest 1.5% on the previous corresponding period, starkly underperforming 5% growth at Coles. We are reluctant to extrapolate the differential in sales growth of the two largest Australian supermarket chains over a relatively short time period. There are temporary factors for divergence in near-term sales momentum, including the timing of promotions and Coles' collectibles marketing.
Woolworths' shelf prices fell slightly on last year, and volumes undershot population growth. With quarterly sales tracking below our expectations, we lower our fiscal 2024 revenue forecast marginally. This reduces our fiscal 2024 EPS forecast by 3% to AUD 1.41. Our long-term outlook is broadly intact, and although shares have fallen around 20% over the past 12 months, narrow-moat Woolworths still trades 10% above our unchanged AUD 27.50 fair value estimate.
We share management's view that the next 12 months look tough for Woolworths. A combination of heightened competition and low inflation points to very modest revenue growth in fiscal 2025. We expect Australian supermarket sales will grow by 3%, adjusting for 53 trading weeks in fiscal 2024. Meanwhile, Woolworths' wage bill, closely linked to the minimum wage, should continue to rise. In June 2024, the Fair Work Commission is set to deliver its fiscal 2025 minimum wage decision, and there is a risk of wage growth outpacing sales growth. Alongside the cost of ramping the new distribution centers, this contributes to our forecast of a 40-basis-point operating margin decline for Australian supermarkets, to 4.7% in fiscal 2025 from a forecast 5.1% in fiscal 2024.
The remainder of their research report remains from Feb 21 2024 ...
Business Strategy and Outlook | by Johannes Faul Updated Feb 21, 2024
Woolworths is one of Australia's largest retailing groups, operating supermarkets and discount department stores. Its market capitalization is around AUD 45 billion, with annual sales of over AUD 60 billion.
Woolworths has a narrow economic moat characterized by an extensive supermarket store network, serviced by an efficient supply chain operation coupled with significant buying power. It operates in the very competitive supermarket and discount department store segments of the retail sector. Intense competition has taken its toll on margins. Management has reset prices lower to drive foot traffic and increase basket sizes. Volume growth is vital for maximizing supply chain efficiencies.
To contextualize Woolworths' enormous scale advantage, its Australian food sales of over AUD 40 billion represented about 15% of total Australian retail sales in fiscal 2022. The percentage increases substantially if sales are strictly comparable. For example, Woolworths has negligible exposure to cafes, restaurants, and takeaways, where sales totaled some AUD 60 billion. We estimate that a more representative percentage on a strictly comparable basis would fall closer to 20%.
Key risks involve increased competition in the Australian retail landscape and reduced consumer spending. The change in ownership of Australia's largest retailer, Coles, in 2007, was the catalyst for increased price competition by both groups to win market share, while the entry of Amazon Australia could raise the competitive bar in the future. The aggressive expansion of low-cost discounter Aldi has altered and further segmented the grocery sector and increased competitive pressure. A reduction in the rate of growth in consumer spending would affect revenue growth and could affect operating margins. Increased frugality and heightened deflationary pressures would crimp top-line sales growth, and relatively high fixed-cost leverage would affect margin.
However, Woolworths is well positioned to withstand cyclically weak consumer spending. Woolworths is a defensive stock, with food retailing generating most of group revenue and profit, a solid balance sheet, and a narrow moat surrounding its economic profits.
Economic Moat | by Johannes Faul Updated Feb 21, 2024
We believe Woolworths has a narrow economic moat sourced from cost advantages underpinned by its significant scale. As of 2022, we estimate Woolworths to have 36% market share with roughly 25% more sales and stores than the second-largest supermarket in Australia, Coles, which commands 28% market share. In recent years, Woolworths has maintained an average EBIT margin of 5% in Australian food and about 50 basis points ahead of Coles, whilst also managing to expand market share. Woolworths’ growing market share and superior operating margin over Coles and other competitors is attributable to its narrow economic moat and also provides Woolworths with extra protection to defend its market dominance and the ability to outcompete on price cutting.
Woolworths’ dominant scale allows it to leverage distribution, administration, and marketing costs in a way that smaller competitors cannot. From this alone, we estimate Woolworths to have an operating margin advantage over its closest competitor. Aside from Coles, Woolworths also has superior bargaining power due to its higher sales volumes over its competitors, and is able to negotiate lower prices and better terms with its supplier. As a result of their combined 65% market share—which they have held steady despite Aldi’s growth—consumer packaged goods firms require both Woolworths and Coles as distribution channels to penetrate the Australian market comprehensively. A significant shift in their bargaining power is unlikely to occur over the next decade. As a fully integrated supermarket, Woolworths also has an additional cost advantage over independent retailers. This includes those within the IGA network—representing 11% of the Australian food retailing market—which only earn a retailing margin, with the wholesaler margin captured by others, like Metcash.
We view a narrow moat rating to be more appropriate than wide. Aldi continues to expand its network and improve and broaden its product quality and range, but we forecast its sales growth to slow significantly toward the overall market’s growth rate of 4% by 2024. There is also the latent threat of Amazon Australia introducing its Fresh category, but in our view this is unlikely to have a material impact in the foreseeable future, given the long lead time and difficulty to replicate Woolworths’ store network and market share—in-store and online—as well as its mature relationships with Australian suppliers. This is evidenced by Aldi taking nearly two decades before reaching close to 10% market share, still a relatively small player.
Higher private-label penetration presents an opportunity for Woolworths to improve its sales mix to higher-margin products and broaden its offering to price sensitive customers for whom it competes with Aldi. Private-brand penetration in Australia significantly lags key European markets, with Australia at around 20% compared with the U.K., for example, at over 40%.
Amazon Fresh is having mixed results in other jurisdictions and the online behemoth hasn’t yet proven to be as disruptive in groceries as it has in books, electronics, and sporting goods. Amazon currently operates in about 20 countries, with Fresh available in select cities in only five of them (United Kingdom, United States, Japan, Germany, and India). In the U.S., food retail is currently sitting at around 3% e-commerce penetration compared with over 10% across all retailing, and Amazon’s share is only a fraction despite launching Fresh over a decade ago, in 2007. Germany is Amazon’s second-largest retailing market after the U.S. We estimate Amazon has about 25% share of the German food and liquor retailing online market. However, since online penetration of the German supermarket sector is less than 2%, Amazon’s share of the market is still less than 1%. Amazon’s German website was launched in 1998 and Amazon Fresh has been available in select cities since 2017 We estimate Woolworths’ online sales to account for 8% of its top line by the end of the decade, up from around 5% currently. In Australia, we estimate 3% of groceries are currently sold online.
Meal kit deliveries are becoming increasingly popular, also competing with supermarkets, but here the growth is from an exceptionally low base of about 0.5% market share, and due to the higher cost, meal kits are unlikely to penetrate all consumer segments. We expect the channel to remain a fringe player.
Fair Value and Profit Drivers | by Johannes Faul Updated Feb 21, 2024
Our fair value estimate is AUD 27.50 per share. We do not expect Woolworths to widen its margins toward similar levels it had enjoyed before 2016, as the Australian supermarket sector has structurally changed with the reintroduction of the discount channel. Aldi is taking market share from the established supermarkets, intensifying competition among them for the remaining market. We expect supermarkets to compete by passing on efficiency gains or cost savings to consumers through price cuts, instead of expanding operating margins and potentially losing share.
As a result, we expect Woolworths to successfully defend its market share in food retailing at around 36% in the long term against key competitor Coles and other grocers, but this will be achieved by passing on efficiency gains to its customers, capping operating margins.
Our fair value estimate implies a forward fiscal 2024 price/earnings ratio of 19, an enterprise value/EBITDA of 6, and a free cash flow yield of 5%. Australian supermarkets are the most significant determinant of our discounted cash flow model, with average annual revenue growth of around 4% during the next five years. We forecast group EBT margins to remain relatively stable from fiscal 2026. Despite continued capital investment, we expect return on invested capital to average 12% through 2028, compared with our cost of capital assumption of 7.2%, providing support for our opinion that Woolworths has a narrow economic moat.
Risk and Uncertainty | by Johannes Faul Updated Feb 21, 2024
Woolworths gains comfort from its market-leading operating margins in the core Australian supermarkets segment. However, several competitors could raise the competitive bar: Arch rival Coles supermarkets; number three discount supermarket chain Aldi; Wesfarmers with Australia's largest discount department store operations; the possibility of U.S.-based Costco stepping up its investments in the Australian store network; and potentially Amazon Fresh disrupting the industry in the longer term.
Besides a potential loss of market share to peers, intensifying price competition poses a threat for the industry. Low food price inflation below wage and rent hikes may result in operating margin pressure. From a macroeconomic standpoint, a prolonged period of weak consumer spending growth might weigh on earnings.
We conclude that environmental, social, and governance risks for the retailer are immaterial to our fair value estimate and are well mitigated by existing processes and procedures.
Woolworths mitigates its risk associated with unmaintainable sourcing with policies and procedures that are expected to be complied with by employees and suppliers and are overseen by the Audit, Risk Management, and Compliance Committee. Examples of policies include the Woolworths Group Animal Welfare Policy and Responsible Sourcing Standards.
In managing the ESG risk associated with Woolworths’ carbon footprint, Woolworths has made several commitments including using only recyclable, reusable, or compostable packaging for own brand products by 2023 and committing to be net carbon positive by 2050. Initiatives to achieve these include the rollout of REDcycle bins within retail stores, and the installation of LED lighting and centrally controlled air-conditioning.
ESG risk associated with the retailing of tobacco products within Woolworths retail brands is largely mitigated by the heavy taxes imposed on these products by the Australian government.
Capital Allocation | by Johannes Faul Updated Feb 21, 2024
We ascribe Woolworths an Exemplary capital allocation rating. The balance sheet is sound, investments are exceptional, and distributions to shareholders are appropriate.
Woolworths is a defensive retailer which faces minimal revenue cyclicality because virtually all of group operating income is derived through grocery retailing.
Woolworths has a moderate level of operating leverage within its cost base. Rental expenses, the second largest operating cost, represent a significant portion of the cost base and are driven by long-term store leases that typically have minimal ability to change in the short term, whereas staff costs, the largest operating cost, are sticky in the short term but can be flexed up and down to deal with increases and decreases in work load.
Woolworths’ balance sheet is in excellent shape. Financial leverage, as measured by debt/EBITDA, is minimal, and we estimate a highly maintainable three-year forward average of 1.2. The weighted average maturity of its debt is around four years. As long as sales increase, Woolworths also enjoys the benefit of operating with negative working capital as customers predominantly make payments immediately in store and suppliers are typically on extended payment terms.
Woolworths' investments consistently generate economic profits, and these are tailored toward strengthening the supermarkets business’ economic moat. Investments in new stores and store renewals can leverage the scale and cost advantages that the supermarkets business enjoys while investments in online channels and fulfilment methods have the benefit of making Woolworths’ competitive advantages more resilient to the threat from other online retailers.
Woolworths is a relatively low growth business, and a high level of distributions to shareholders is recommended given the reduced avenues to invest capital at a rate above the cost of capital. Woolworths’ historical payout ratio of 73% is highly appropriate and value maximizing for shareholders given the high level of franking credits the business generates.
Woolworths also appropriately returns surplus capital from the divestiture of noncore assets to its shareholders. This is exemplified by the divestiture of the retail fuel network to EG Group in 2019 and return of capital to shareholders via a AUD 1.7 billion off-market share buyback that utilized excess franking credits.
