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Woolworths has been a wonderful business and a core part of every Australian investment portfolio for a very long time. It has consistently produced internal returns on capital of 14-15 per cent, well above its cost of capital and as a result has been a big winner for investors. In the 10 years up to the middle of last year, Woolworths had produced a compound annual growth in its share price of 12 per cent and paid a total of $12 a share in dividends, for a total shareholder return of 16 per cent per annum. Over the same 10-year period, the market's total return has been 7.2 per cent per annum, so it’s always been an investment truism that the more Woolworths you own, the happier you'll be.
But the past 12 months have been a nightmare for those investors, leading up to the removal this week of CEO Grant O'Brien. The share price has dropped $10, or nearly 30 per cent, in a year and is now back to where it was in March 2007. The 10 year capital return is back to 5 per cent; the eight-year return, zero – dividends only.
Three things have happened, only one of them obviously self-inflicted (although in business there are no excuses, so it’s all self-inflicted really).
1. Coles lifted its game under the leadership of Richard Goyder and Ian McLeod
2. Aldi became became the fastest company in history to reach $5 billion in sales, putting enormous pricing pressure on both Woolworths and Coles
3. Woolworths’ foray into home improvement has been a disaster, so far
These things have been picked over at length in Eureka Report and elsewhere, so I won’t do it again… except to repeat the table I showed you two weeks ago of some grocery price comparisons published by Choice:
According to Choice, Aldi’s prices represent an average 26 per cent discount on Woolworths’ private label groceries and a 50 per cent discount on the basket of leading brands. Now that’s what I call disruptive – a devastating price competitor in a business where cost is everything. The only thing stopping Aldi laying waste to both Woolworths and Coles is the two incumbents’ foothold on the best sites, although as Rose Blumkin, the founder of Berkshire Hathaway's Nebraska Furniture Mart and a legend of discount retailing in the US once said: "If you have the lowest price, they will find you at the bottom of a river.”
Also, what’s not well understood about Aldi is the importance of its relationships with suppliers. As we know, food growers and manufacturers absolutely hate Coles and Woolworths. The big supermarkets bully them, charge them a whole range of different fees for shelf space and marketing and then stuff them around on payment terms. If the suppliers complain, they get cut off and their lives are ruined.
Aldi, on the other hand, is loved by suppliers because it pays them one transparent price, no hidden charges, and always on time. It’s true that there are no brands other than Aldi house brands, so no scope for a supplier to build brand equity themselves, but that doesn’t matter if you get a steady income without being bullied. I think this difference between the arrogant incumbents and the discount challenger is very important.
The other thing to mention is that I once went into a Masters store (I usually shop at Bunnings). The place was empty – no customers, no staff (that I could see). It felt like I had stepped into a post-apocalyptic movie set, complete with spooky muzak. Never again.
But all that aside, and accepting that this is a company with a few problems that just moved its CEO on, the question is whether the Woolworths’ share price has now fully discounted those problems. To get to the bottom of this, I turned to my friend Justin Bown of Juno Partners, who analyses the wealth creation and true value of the top 300 companies. Basically he doesn’t just look at what a company is earning – he takes into account the amount of capital that’s being employed. Companies often increase their earnings by pouring more capital into the business, and destroy wealth in the process.
Justin’s analysis shows that at June 30, 2014, Woolworths’ economic profit (return on capital above the cost of capital, times capital employed) had plateaued and started to decline. The spread between the cost of capital and the return was still healthy (7 per cent), but it was starting to narrow.
According to Justin, the price a year ago of $35 a share implied that investors were expecting future return on capital to be 10 per cent, down from 13 per cent in previous years. That assumes compound capital growth of 5 per cent a year, down from 8 per cent capital growth over the past five years (Justin is assuming that with lower profits, less capital will be reinvested in the business). If you assume 7-8 per cent capital growth instead, Justin’s model produces an implied return on capital from the $35 share price of 8-9 per cent.
Using the same metrics, the current share price of below $27 implies an expected return of capital of 8.9 per cent, assuming 5 per cent capital growth.
This analysis means that Woolworths is currently priced for a collapse in its return on capital from 13 per cent to 9 per cent. That in turn implies a halving of its gross profit margin.
That’s what the market is telling you is going to happen to Woolworths in the years ahead. Will it? Well, that’s why investing involves risk. It might happen, then again chairman Ralph Waters might find a retailing genius like Ian McLeod who manages to find Woolies’ mojo again.
Or maybe a big private equity fund decides that Woolies is a good break-up and turnaround prospect and is prepared to pay over $30 a share before doing what Anchorage Partners did with Dick Smith (they bought it from Woolworths for $20 million and floated it for $500 million after an embarrassingly short time).
If you’re asking me what I think, and bearing in mind that I’m not a retail analyst and the only Woolworths shop I go into is Dan Murphy’s (albeit, quite a lot …), I reckon it’s going to be very hard for Woolworths to hang onto a profit margin of 6 per cent with Aldi, Costco and Coles chomping away at the market. The company's best days seem to be behind it, and on that basis $27 looks expensive, if anything. And you definitely wouldn’t buy until you have seen the new CEO and heard the new plan.
Speaking of industry disruptions and challengers, I’ve started using Uber, the drive sharing platform that is taking on taxis.
My goodness what an excellent service it is! You tap the app when you want to ride; it knows where you are via GPS and quickly tells you the name of the closest driver and how far away they are, complete with a picture of the person. He or she arrives at precisely the time nominated, takes you where you want to go in a nice car, with a map in front of them so they can’t get lost (and they can’t refuse to take you, no matter how short the journey) and then you just get out – no money changes hands because it’s deducted from your account. The driver gets 80 per cent and you are required to rate him or her out of five, just as the driver is required to rate you as a passenger. Thus a database is built up of the qualities of each and over time this influences how everyone behaves.
Uber is often equated with Airbnb, the accommodation sharing platform, but I’ve used that as well and I think Uber is far more disruptive. I spoke to the local head of Airbnb last week, and they only have 4 per cent of the market so far, with a dream of getting to 10 per cent one day.
Uber has the potential to completely destroy the taxi industry in my view. My children and all their friends refuse to use taxis now, because the Uber service is safer, cleaner, more reliable, drivers don’t reject them as with taxis and – this is the main thing – it’s a non-cash payment system. No fishing for cash or fiddling with credit cards, on which Cabcharge takes a usurious 10 per cent clip.
Uber launched in Australia in 2012. Cabcharge’s share price peaked at $6 in September last year and is now $4, heading south. I think the writing is on the app, so to speak, for Cabcharge.
This morning’s news is that the European Central Bank has increased emergency lending for the big four Greek banks because the pace of withdrawals has increased and they might not have been able to open on Monday. The Wall Street Journal has quoted officials saying it doesn’t quite constitute a bank run yet, just a “bank jog” (nice one!). Deposit outflows reached €1 billion on Thursday alone and €3 billion for the week. Also, their non-performing loans range from 32 to 39 per cent, so interest income has dried up – they rely almost entirely for liquidity on the ECB.
So call it what you like – run, jog, sprint or walk – the banks are in trouble, and the focus is now on them – whether the government defaults on its forthcoming repayment to the IMF or not, they are running out of money – or more precisely they are running of collateral. Barclays estimates they have about €33 billion in eligible collateral left – about a quarter of the remaining domestic deposits.
As you will no doubt recall, I came back from Athens in April all gung ho about its prospects, saying that not only would it not default and “Grexit” the eurozone, the place was ready to take off because it had become a low-wage country and had a new entrepreneurial spirit. I wrote then that these sorts of negotiations always go to the wire, because if anyone folds their hand early they would think they haven’t got the best deal possible. As deadline approaches, I predicted, the heat would rise.
Well that is indeed what is happening. The deadline for the next repayment of €1.5 billion to the IMF is next week and both sides are talking more than tough, they’re talking Armageddon, saying they will refuse to budge, and last one out please shut the door and turn out the lights. Markets and the media believe them. Stories about the inevitability of default and Grexit are appearing every day, stockmarkets are getting volatile, the pace of bank withdrawals is increasing and Kohler is looking stupid (not an entirely new experience, I regret to say).
OK, well on balance I still think I’ll be proved right, but the chance of a terrible end to this crisis has definitely increased.
The reason I’ll be wrong, and Greece goes into default next week, is because neither side now has much to lose by saying “No”. Europe’s financial system looks to have been buttressed by the ECB’s huge quantitative easing program, announced three days before the Greek election in January, and the effect of the fiscal contraction required of Greece to get another bailout would be not much better, and possibly no better, than the recession that would result from default and the complete collapse of the banking system, if that’s what occurred.
My advice is to ignore the whole thing … well, watch it as you would a movie (Clash of the Titans?) but don’t get sucked in.
The Federal Reserve’s Open Market Committee met this week and issued a statement that didn’t say much, and then chair Janet Yellen didn’t say much at a press conference.
Here is the new “dot plot” compared with the same thing in March:
To remind you: the dots are interest rate forecasts from the 17 members of the FOMC (I wish the Reserve Bank board would do this!).
Just eyeballing it, it’s clear that the forecasts are generally lower. Most thought the Fed funds rate would be between 0.5 and 0.75 per cent by the end of 2015; now there are five each predicting 0.25-0.5, 0.5-0.75 and 0.75-1. The same two are predicting no change this year.
What does it mean for you? Not a lot.
In all the focus on examining the dots as if they were chicken entrails, most commentators seemed to ignore the fact that the Fed’s economic assessment in the statement was upgraded. Basically the Fed was simply acknowledging reality: whereas previously “growth slowed”, not it “expounded moderately”, and whereas jobs growth “moderated”, now it “picked up”. However the press conference was completely useless in fleshing this out, so it’s impossible to reconcile the apparent downgrade to interest rate forecasts with the upgrade to the economic assessment.
Except for blowing my own bags a bit. I have long been with the two FOMC members who are predicting no change to US rates this year because I think technology and automation have changed the way economic growth affects inflation. Unemployment can be lower without increasing prices because of the downward impact on prices of the digital revolution – specifically robotics, 3D printing, cloud computing, Uber (see above) and so on. Economists don’t take enough notice of this because they just watch past data from the statisticians.
Longer term interest rates will rise more quickly than cash rates because central banks will be – deliberately – behind the curve, while the bond market is entering a structural bear market after a 34-year bull market – probably the greatest in history.
First interview this week is with James Kelly, CEO of retirement village developer Lifestyle Communities (and an old friend of mine).
He and two partners started the business about 12 years ago and they now have a dozen “communities” either finished or in the pipeline. They raised $36 million in new capital in 2012 and are now just recycling capital – building, selling and then building again. Market cap is $257 million and the founders own about 30 per cent, so it’s quite liquid.
The business is at the affordable end of retirement accommodation – the houses/units are priced at 75 per cent of the median home price in that suburb. They achieve that by selling full title to house but only renting the land to the customer on a 90-year lease. Because the land is rented, it attracts the Federal Government rent subsidy for pensioners.
It is a steadily growing annuity style business with a clear dividend policy, which James spells out in the interview, which you can watch and/or read here.
My second interview this week is with Craig Richardson, CEO and one of the founders of Wynyard Group, another $250 million market cap business based in New Zealand that is planning to dual list in Australia in a couple of months.
This is a fascinating business. Its specialty is crime and intelligence; its customers are police forces and intelligence services, as well as financial institutions and other corporations. It both sells the software and services it, so there’s licence income and recurring annuity-style income. As for the share register, it’s virtually all institutional – quite unusual for a business of this sort.
You can watch and/or read the interview by clicking here.
A few weeks ago I talked about some big changes we’re making to Eureka Report on July 1. One of the new things we’re introducing is a dedicated research service for income stocks, to help you in the hunt for yield. You can see me talk a bit more about that here.
Readings & Viewings
Greece: the next chapter of the GFC, or the next Y2K crisis? Yes.
How financial engineering could help resolve the Greek crisis.
A Greek Suicide? Anatole Kaletsky worries that Greece's government does not understand that it has lost its only weapon in debt talks.
Krugman: Nothing fills me with quite as much despair as the persistence of the story line that it’s all about continuing Greek fecklessness, that the Greeks haven’t done anything.
Barrie Cassidy: We already knew long before this week that there was a crisis of politics over policy. But even allowing for that, this week in Canberra was one that surely drove voters to new depths of despair.
IMF: trickle down economics does not work. Oh? What about in Greece?
The Chinese have invented a smartphone app for dobbing in corruption, would you believe.
Blackberry is dying a loud and undignified death – a list of six dying companies (including Amazon, which has never made money, but I don’t think it’s dying. I mean, come on!).
Uber drivers: we’re not employees, we’re independent contractors.
On the subject of Uber, in the US it has launched a service called Uber Eats, which looks a very good idea.
YouTube could change the way we view sport in Australia.
I saw this on Twitter the other day – a great demonstration of Pythagoras’ theorem.
Economists react to the Fed’s June statement: mixed messages.
If you haven’t caught up with the Sarah Ferguson’s doco on the Rudd-Gillard years, called The Killing Season – do it now!
Stop revering Magna Carta says Tom Ginsburg in the New York Times – its fame rests on myths,
The art of observation, and why genius lies in the selection of what is worth observing.
Inside the Islamic State: Far from being an undisciplined orgy of sadism, ISIS terror is a systematically applied policy that follows ideas put forward in jihadist literature.
At the opposite end of the scale: The Pharaohs of Silicon Valley – my journey through Google’s headquarters.
Steve Harley and Cockney Rebel doing Make Me Smile from 1975.
Jon Stewart's monologue on the South Carolina shootings: we won't do jack shit about it.
The glorious imbecility of war.
Happy Birthday Chet Atkins, who would be turning 91 today if he hadn’t died in 2001. Here he is doing some typical, foot-tapping guitar picking.
Thanks for all the kind condolences I received this week in response to the eulogy for my father included in last week’s. To close off the subject, here’s a link to Billy Bragg’s Tank Park Salute, written as a tribute for his father after his death:
A tree taps on the window pane
That feeling smothers me again
Daddy is it true that we all have to die
You’ve got to be careful of who you marry, having the headline of the wedding notice in mind:
Shane Oliver, AMP
Investment markets and key developments over the past week
Shares had another messy and mixed week with worries about Greece weighing, particularly on European shares. Japanese shares also fell and Chinese shares had another plunge as IPOs surged and the authorities further tightened rules around bank exposure to margin trading. Against this though, US shares were helped by good economic news and a benign Fed and Australian shares also continued to bounce from previously oversold conditions. Bond yields fell except in some peripheral eurozone countries on Greece worries. The US dollar fell on expectations that Fed rate hikes will be gradual and this saw the Australian dollar rise slightly despite soft commodity prices.
The Greek standoff continues. The lack of progress in negotiations and the negative rhetoric from the Greek Government is clearly worrying for investors and the risk of no deal, setting Greece on a path of default and exit from the euro has clearly gone up. However, several points are worth noting:
First, there is still a way to go yet. While a €1.5bn payment to the IMF is due June 30, an actual default will not come till the IMF writes a letter informing Greece it’s in default and this may not come till some time into July. Also if a late agreement is reached the IMF, ECB and EU may simply agree to delay payment until any necessary parliamentary votes and referendums occur. The next event to watch is an emergency Eurozone leaders meeting on Monday
Second, Greek banks may help bring the crisis to a head because without continued ECB support the escalating outflow of deposits may soon force them to close which will bring on a credit crunch in Greece. Either this or the fallout from a default (the so-called “Graccident”) could force the Greek “Government” to soften its stance.
Third, a consistent 70 per cent or so of the Greek population wants to stay in the euro and the Greek Government knows this.
Fourth, it’s in the interest of both sides to reach an agreement: for Greece to avoid a banking crisis, economic mayhem that would follow if they have to balance their budget immediately and forced exit from the euro; and for creditors to preserve as much as possible of the €300bn or so lent to Greece and to head off any contagion. In this regard the war of words around Greece is very similar to that amongst US politicians ahead of its various debt ceiling deadlines.
Finally, although a Graccident need not mean a Grexit, even if there is to be a Grexit the rest of Europe is in far better shape now than in 2010-12 with Portugal and Ireland now both off bailout support, peripheral countries having reformed their economies and reduced their budget deficits and the ECB in a far stronger position to protect countries from attacks on their bond markets (via both its QE program and its Outright Monetary Transactions program which enables the buying of bonds in troubled countries).
While the Greek mess is unnerving & may go on for a while yet, it’s unlikely to drive a return to the mini bear market in shares we saw back in 2011 at the height of the eurozone crisis.
Chinese shares have had another sharp pull back with the Shanghai composite having had a 10 per cent fall from its June 12 high. After rising 140 per cent over 12 months and around 50 per cent year to date such volatility is to be expected as it has risen a bit too far too fast. The easy gains are probably over and a period of correction would be healthy. However, it’s worth reiterating that the Shanghai composite index on an historic PE of 21 times is still below its long term average and should benefit as further monetary easing comes through. In fact with Chinese authorities wanting the share market to be strong but not manic, the latest share market correction means that it wouldn’t be surprising to see another PBOC rate cut or required reserve ratio reduction soon.
The Fed remains on track to hike later this year, but it’s looking more gradual. The message from the Fed’s latest meeting was relatively benign with growth and the jobs market looking stronger and a rate hike on track for later this year, but the hike remaining dependent on a further improvement in employment and confidence that inflation has bottomed. The Fed has also revised down its interest rate expectations (the so-called dot plot) reinforcing that rate hikes will be gradual. My base case remains that the first hike will be in September – but the risks are that a combination of slower growth, Greek related turmoil or a stronger US dollar could push this out to December. So far it feels like the experience with the taper in 2013, with investor nervousness ahead of the taper, but by the time it started it was already factored in.
Major global economic events and implications
US economic data was mostly good consistent with the view that growth has picked up after the March quarter slowdown, albeit not as strongly as occurred last year. On the soft side, industrial production fell in May and manufacturing conditions in in the New York region were soft. Housing starts also fell in May, but this followed an upwards revision for April and in any case the more forward looking permits to build new homes and the NAHB home builders’ conditions index both rose solidly indicating that the housing recovery is continuing. On top of this, manufacturing conditions in the Philadelphia region improved significantly in June, jobless claims fell and the US leading index rose. At the same core CPI inflation was weaker than expected in May with the annual increase falling to 1.7 per cent, partly highlighting why the Fed is in no hurry.
In the eurozone, bank take up of cheap ECB Targeted Long Term Refinancing Operations (TLTRO) money was strong for the second quarter in a row adding to confidence that bank lending will continue to improve.
In Japan, the BoJ left monetary policy unchanged but this was as expected. Pressure for more easing remains though, and despite BoJ Governor Kuroda's confusing comments on the value of the Yen, it’s likely that it will see further falls ahead.
China saw more evidence that property prices have bottomed with average of property prices rising again in May. This compares to monthly declines of around 1 per cent a year ago. A stabilisation in Chinese property market indicates that a key source of risk to the Chinese economy is now receding.
Australian economic events and implications
Monetary policy still works. This was the clear message from a speech by Assistant RBA Governor Christopher Kent, who rightly pointed out that it has been up against strong headwinds of the mining investment downturn, fiscal consolidation and a less helpful exchange rate. The RBA probably does not want to cut rates further and is hoping Fed tightening will negate the need but the clear message from Governor Steven’s the week before and Kent’s assessment that rate cuts have been working indicates that it will cut again if needed. So while the Minutes from the RBA’s last Board meeting offered little new, my view remains that another rate cut is a 50/50 proposition with the August meeting being the one to watch.
By Craig James, Commsec
Mid-tier economic indicators
There are no ‘top shelf’ indicators due for release in Australia in the coming week. That is, no indicators that have potential to move financial markets like retail trade, inflation or economic growth. So the focus is on mid-tier indicators. In contrast there is a bevy of key indicators in the US.
In Australia, the week begins on Tuesday when the Bureau of Statistics (ABS) releases data on overseas arrivals and departures for March. The ABS is still in ‘catch-up’ mode with the data on ‘people flows’ due to processing issues with passenger cards. But the ABS should be basically up-to-date by early August.
The overseas arrivals and departures information contains figures not just on tourism flows but also longer-term migration. The data is important for tracking activity in the tourism sectors, but also retail spending and the job market.
At present tourist arrivals are up 6.9 per cent for the year, driven by Chinese arrivals, while departures are up by 4.5 per cent. And net permanent and long-term arrivals are at the lowest level in 3½ years (since July 2011).
The other key indicators in the coming week are all released on Thursday. The ABS releases demographic data for the March quarter together with job vacancies and the “Finance and Wealth” publication.
The demographic data is a little dated, with figures covering December quarter last year. But the data is important for businesses and policymakers, covering birth, deaths and changes in migration levels. Australia’s population growth has slowed, but at a 1.53 per cent annual rate, it is amongst the highest rates in the developed world.
The Finance and Wealth publication includes a vast array of data. The figures can show how much cash certain sectors are maintaining, foreign holdings of bonds and equities, and wealth levels of Australian households. We may not feel wealthy, but data shows that wealth is at record highs.
Also on Thursday, the ABS releases data on job vacancies. If vacancies rose in the past three months, it will confirm that the job market is gradually strengthening.
Bevy of housing data in the US
There is the usual bevy of economic indicators due for release in the US over the coming week, with the housing market especially in focus.
The week kicks off on Monday in the US with the national activity index for May as well as May data on existing home sales. Existing home sales eased by 3.3 per cent in April, but economists expect that the loss was largely erased in May.
On Tuesday, data on new home sales is issued together with durable goods orders, monthly home prices, the influential Richmond Federal Reserve survey and the weekly survey of chain store sales.
Economists expect the proxy for business spending (durable goods orders) rose by 0.2 per cent in May after falling by 1 per cent in April. New home sales may have edged up a little further after the 6.8 per cent gain in May. And data should confirm that home prices are rising at an annual rate of just over 5 per cent in April.
Also on Tuesday, the “flash” readings of manufacturing activity in June will be released in the US, China and Europe.
On Wednesday the final estimate of US economic growth for the March quarter is released together with the usual weekly data on housing finance activity. Current data shows that the US contracted at a 0.7 per cent annual rate in the March quarter, but this may be revised to a 0.2 per cent fall.
On Thursday the weekly data on jobless claims is issued together with personal income and spending, the Kansas City Fed manufacturing survey and the Markit “flash” reading on the services sector.
And on Friday the “final” reading of consumer sentiment for June will be released. The preliminary reading showed a lift from 90.7 to 94.6.
And Greece will remain centre-stage over the week as a June 30 deadline for a debt deal draws near.
Sharemarket, interest rates, currencies & commodities
The Australian sharemarket has lifted 3.9 per cent so far over the 2014/15 year. And while that doesn’t sound like a remarkable gain, it places Australia in 35th position of 73 global markets monitored.
The strongest sharemarket over 2014/15 has been Venezuela, with the IBC index up almost 550 per cent. Next best has been China (up 152 per cent) and Argentina (up 44 per cent). Notably the Japanese sharemarket is in 4th position, up by almost 35 cent.
At the other end of the leader-board are Greece (down 36 per cent), Russia (down 30 per cent) and Columbia (down 26 per cent).
Other notable moves have been by Germany (up 12 per cent), the US Dow Jones (up 6.6 per cent), and the UK (up less than 1 per cent).