MARKETS SPECTATOR: A trio of Woolies worries

A possible exit by US hardware giant Lowe's from the Masters hardware joint venture is among three reasons why one broker is downgrading Woolworths.

Research firm CLSA has this morning downgraded Woolworths (WOW) to sell from underperform, but maintained its price target of $33.30.

This downgrade was premised on three underlying reasons.

1) The stock has run very hard and is now trading on a price-earnings to growth ratio of 3.4, which puts it at an all time high in terms of price.

2) CLSA believes there is a very real risk that Lowe’s will look to exercise its option to exit its Masters JV.

3) The broker sees the risk of regulatory restriction increasing, which will impact growth.

CLSA said a PEG of 3.4x defies logic.

“We firmly believe that food retailing, perhaps along with financial services, is the best industry structure in Australia. Relatively high barriers to entry, significant negotiating power over suppliers, a loyal band of customers and limited substitutes allow for excess returns. That said, with world’s best EBIT margins, an incredible 7.7 per cent in 2013 first half, we feel the industry benefits are more than reflected in Woolworths’s current margins and rating.”

Expanding on its thoughts regarding Lowe’s, under the agreement that was struck the best part of four years ago it was granted a put option for its 33 per cent stake exercisable after the fourth anniversary of the agreement. CLSA believes this will fall around August 2013 and if exercised it believes Woolworths would have to pay around $550 million, which is a pretty tempting figure for a loss-making business.

CLSA notes that not a day goes past where there is not a press article calling for an inquiry into the power of the supermarkets and the alleged abuse of that power, particularly as It relates to suppliers and how they are feeling the pressure even more.

Consequently, the broker believes the combination of the above three factors could be the tipping point for investors to start viewing the Woolworths story from a differing angle, which it notes as necessary for a sell recommendation to work.