Value Investor: Wowing the punters, year after year

Woolworths’ ability to drive supply chain improvements is one of the secrets to its success, even as discretionary spending stays weak.

Woolworths Ltd (WOW) has a great track record of value creation for its shareholders, evidenced by a CAGR (compounded annual growth rate) in intrinsic value per share of 12.43 per cent per annum from 1993 to 2013. WOW has consistently grown earnings and dividends per share over the last 10 years, adding to credibility with investors.

WOW is a strong franchise that generates earnings margins well ahead of its peers. Despite subdued retail conditions, a rejuvenated competitor in Coles and a loss-making Masters, its FY13 result showed strong performance yielding growth in sales and profit.

WOW achieved 6 per cent growth in sales to $58.5 billion, 24 per cent growth in NPAT to $2.26 billion, and 19 per cent growth in EBIT to $3.65 billion. The result was underpinned by strong earnings momentum in its Australian Food & Liquor segment.

WOW achieved these results after Masters (Home Improvement) losses widened from $96.7m to $138.9m. Without Masters, the result would have been even better.

Consumer spending is under pressure and while discretionary retailers have struggled, WOW and Coles have been resilient reflecting the non-discretionary component of their sales and ability to drive lower prices with efficiency gains.

WOW’s ability to drive supply chain efficiencies and pass these on to customers is core to its success and one of the stock’s attractions. Over the past 10 years, WOW has expanded its margins over three percentage points.

Cheaper buying, supply chain efficiencies, more effective promotions, private label and reduced shrinkage contributed to gross margin expansion of 30bps to 26.9 per cent in FY13. In the context of increasing competition and operating off a high base, is further margin expansion achievable?

The improvement in Coles’ competitiveness is the key risk to WOW’s margins and intrinsic value growth. Coles is an aggressive, value-focused competitor and there is a rapid industry-wide supermarket store rollout from Coles, WOW, IGA and ALDI, which will dilute returns for all supermarket operators.

FY13 was the year the independents lost out, with Metcash delivering flat earnings and downgrading guidance. In contrast, WOW and Coles both delivered strong results by eating up market share from the smaller players. Coles reported earnings growth of 13.1 per cent ahead of sales growth of 5.2 per cent due to better operational efficiencies and the progressive renewal of the store network. We expect FY14 will be more challenging for the dominant players with a price war the greatest risk to WOW’s earnings growth.

WOW’s EBIT growth may also be constrained by the already high existing key metrics, including margins ahead of peers. There is a high-base effect in WOW. Note trading area expansion was a key driver of EBIT growth while EBIT per sqm growth was still subdued.

Over the last five years WOW’s normalised return on equity (NROE) has fallen three percentage points from 38 per cent to a still strong 35 per cent due to increased competitive pressures, price deflation and the lossmaking rollout of Masters.

What makes WOW attractive to value investors is its high and historically stable NROE. However its large premium of NROE to our 11.7 per cent required return makes the valuation quite sensitive to NROE. If supermarket price competition intensified, squeezing margins, and/or Masters losses worsened, NROE could fall to 32 per cent and the FY14 valuation would be 13 per cent lower at $31.09.

Graph for Value Investor: Wowing the punters, year after year

Figure: Woolworths Ltd Price vs. Value Chart

Source: www.StocksInValue.com.au

The company ranks as one of the best stocks to own in Australia, trading marginally above valuation (see above). Much of its value is priced in. A quality company we will watch closely as it navigates competitive pressures, WOW is on our watchlist to buy on a pullback.

Amelia Bott is an Equities Analyst at StocksInValue, a joint venture between Clime Investment Management, a boutique value fund manager, and the Eureka Report. StocksInValue provides valuations of 400 ASX-listed companies by Clime and equities research, insights and strategy that you won’t find elsewhere, by the StocksInValue analyst team. For a free trial please visit www.stocksinvalue.com.au or call 1300 136 225.