Why I love Woolworths

PORTFOLIO POINT: Expect the Woolworths interim result to be one of the few bright spots in the coming reporting season.
Woolworths (WOW) has again confirmed its place as Australia's true defensive and an absolutely first class company. Its December quarter sales were clearly ahead of analysts’ expectations and broadly defied the awful environment reported by most other Australian retailers. Group sales were up 8.1% on the previous corresponding period to $13.3 billion. Analysts had expected 6.8% sales growth. Every division, except petrol (the price fell), experienced a positive expansion in headline sales. Petrol volumes were up 2.2%, which perhaps indicate Woolworths grew its market share in petrol

What's more, Woolworths continues to take share from Coles and the independents. Comparable store sales rose 7.1% in the quarter (against expectations of 6%), compared to the 3.8% increase reported by Coles. Woolworths’ same-store sales growth continues to be driven by the rollout of the excellent "2010" store format and continued price reinvestment. Similarly, Big W (6.4% sales growth) outperformed Kmart and Target during the quarter.

Woolworths continues to expect "high single-digit 2008-09 sales growth" and there are no cracks in this story. Its return on equity, at 30%, continues to expand as it extracts efficiencies from the supply chain while also driving sales growth via innovation. I get the feeling Woolworths’ interim result will be one of the few bright points this reporting season and that may trigger a further rerating of the stock. I’m happy to stay overweight the consumer staple Woolworths as the consumer discretionary environment deteriorates with unemployment increasing.

Woolworths vs Wesfarmers

Wesfarmers has dramatically underperformed Woolworths since Wesfarmers’ purchase of Coles, and it is hard to see that trend changing anytime soon. It may accelerate. While many commentators believe Wesfarmers has bitten the bullet and dealt with its debt via an extremely dilutive equity issue (and dividend cut), what it has actually done is destroyed its return on equity (ROE).

I believe ROE and price/earnings (P/E) multiples are strongly correlated and there is no doubt in my mind that the widening ROE gap between Wesfarmers and Woolworths will drive a medium-term P/E gap in favour of Woolworths. Remember that there are two key drivers of ROE. The first is margins; the second is gearing. Through the era of freely available and cheap money, Wesfarmers was the master of the universe when it came to using gearing to drive ROE. It paid out all available franking credits, geared up and assumed the market would always be there for future funding. Now it is being hit by falling margins in the coal and industrial businesses and a forced degearing of the balance sheet via issuing grossly expensive equity. Actually, it could have been more expensive equity if it hadn’t somehow been ridiculously included in the financials shorting ban.

Unfortunately, Wesfarmers is the Rio Tinto of industrials. It bet the farm at the top of the asset price cycle and got it horribly wrong. It went ahead with the Coles transaction despite credit markets deteriorating and private equity bidders pulling out of the process. Interestingly, Solomon Lew sold all his Coles shares for cash and didn’t take Wesfarmers scrip. That was a big signal we all should have watched. Wesfarmers paid a private equity multiple at the peak of the asset price, credit and consumer cycles; it managed to turn its scrip from being low-risk and highly rated to a high-risk derivative on credit markets and consumer sentiment.

The equity issue takes away the debt concerns, but the damage done by the debt-fuelled Coles binge will cost Wesfarmers shareholders years of low ROE and low dividends. While the Wesfarmers capital raising should be supported (for a trade) those waiting for it to regain its former glory will be sorely disappointed. The P/E applied to the new lower ROE will be significantly lower than the long run P/E that Wesfarmers had previously attracted.

I don’t think Wesfarmers has made many friends here, particularly with the partially selective placement, and from a fundamental perspective I expect the P/E gap to Woolworths to widen. I’d be buying Woolworths shares into weakness from those making room for the Wesfarmers raising. Woolworths has made Wesfarmers look pretty amateurish over the past 12 months and that will be reflected in the respective medium-term P/Es. Woolworths remains a superbly run business and Australia’s true defensive. Woolworths shares should outperform them sharply over the medium term.

CommBank market leverage works both ways

For the duration of the bull market, Commonwealth Bank commanded a premium to the sector due to the excess earnings growth generated by its market-linked divisions of funds management and insurance. Unfortunately, those same market-linked earnings will lead to CommBank trading at a P/E discount to its peers as this bear market plays out. I think we are all underestimating the market linked earnings risk in CommBank, particularly as markets themselves have got to levels none of us thought possible.

The problem with market-linked earnings are numerous in bear markets. Fees are generally generated off funds under management (FUM) which has been dropping naturally with the market. Second, performance fees are significantly harder to generate when ALL asset classes are falling. Third, investors withdraw their money for fear of further losses exacerbating total FUM and therefore fee drops. Also, inflows dry right up as people preserve what is left of their capital. Then to top it off you get sued by a grandmother who claims the “geared Australian LPT fund” wasn’t appropriate for her needs!

I always find it surprising when analysts, who work in the market, are surprised by a market-related event. A week ago CommBank revealed that FUM fell by 11.9% in the December quarter. That was a big drop, which should have been somewhat unsurprising to market analysts considering what happened to markets in the December quarter.

What is becoming clear globally is that good fund performance versus benchmarks doesn’t stop outflows. Outflows have become indiscriminate with the now stunning situation where many of the best performing long-only funds are seeing heavy redemptions simply because they are open for redemptions. Many top performers are being punished for actually being open for redemptions. That is truly amazing but it’s happening all around the world and CommBank, via Colonial First State, is exposed to it. CommBank experienced net wholesale outflows of $7.4 billion and net retail outflows of $749 million in the quarter, despite the vast bulk of its funds being top-quartile performers.

CommBank’s result in mid-February will be crucial for sentiment towards the entire Australian banking sector. However, the global headwinds in all its businesses, plus the pressure on the asset side of their balance sheet as Australia enters the first recession in 15 years, is going to surely see it deliver disappointing earnings, a weak outlook, and a dividend cut.

Bank dividend cuts are another dent in the income streams of Australian households, the biggest per capita owners of equities in the world. Unfortunately, a disproportionate amount of that household equity investment is in bank equities. My Lord, we are in such a virtuous self-fulfilling spiral of downward trouble, but that is how leverage unwinds. Technical support for CommBank kicks in around $22 (against $26.90 today) and it wouldn’t be surprising to the shares trading around that price post an interim dividend cut. I just have a horrible feeling we are in for a very long period of bank equity underperformance.

Macquarie’s "operational briefing day"

Macquarie Group has kindly asked me to an "operational briefing day" on February 5 with chief executive Nick Moore and other key executives. The briefing is scheduled to go for three and a half hours, but does it really take that long to tell us what we all already suspect?

Macquarie will attempt to put on a brave face but since its last comments on trading conditions, which were downbeat, it is absolutely obvious to all market participants that trading conditions in terms of market activity and deal-flow have got significantly worse in all its markets. Similarly, infrastructure and property stocks have been further derated while the Macquarie "satellite and mothership" model looks decidedly "yesterday". Sure, the Macquarie share price has fallen sharply to reflect the dramatically different trading and asset market conditions, but I don't think we have yet reached the point of maximum pessimism towards Macquarie scrip.

I still find it amazing that its biggest Australian listed competitor, Babcock & Brown, is on "life support" and remains suspended from trading, the vast bulk of Macquarie's global investment bank competitors have either failed, merged or become retail banks and markets are down 50%, yet not a single analyst has a "sell" recommendation on Macquarie.

Do the analysts really think Macquarie is somehow immune to these horrific global trends? Its share price is paying no attention to the analysts but I do smell another round of big 2008-09 and 2009-10 downgrades coming to Macquarie consensus earnings forecasts, which should trigger more quant-based selling.

Right here, right now Macquarie needs to reinvent itself (as we all do). The next three to five years will be totally different for Macquarie as it comes into this downturn clearly over-staffed (keep shorting Mosman property!) and too widely geographically diversified. It also worries me that Macquarie comes into this shocking downturn for investment banks without the steady hand of Alan Moss or David Clarke. It is basically a leveraged derivative over markets, liquidity and asset prices. On that basis I remain of the view that Macquarie's pending earnings contraction is underestimated and you will get a chance to buy Macquarie stock extremely cheaply at some stage this year. The technical target on Macquarie remains around $16 against $26.97 today (the stock might have already reached that level, had it been shortable) and the "operational briefing day" will trigger earnings downgrades.

Some great buying opportunities will present themselves this year but we just have to get the timing absolutely right. I am not trying to be bearish – it's too late for that – just "realistic" and to get the timing of buying right. I also need to keep selling "broken business models" because they will stay broken for a long time. The world remains short capital so if we deploy it we have to be absolutely right on pricing and timing.

Insurance, QBE

The standout sector trouble in global insurance stocks over the past week has been Swiss Re losing 50% and taking all the world’s major global insurers down with it. UK, US and European insurers were all aggressively derated last week on fears that their corporate bond holdings will be devalued, which is a valid concern. It has been a complete bloodbath in insurance stocks, yet because banks have been in the headlines, news of the insurance stock price collapse has been overshadowed.

Marked to market downgrades are pending for Australian insurers and I think the performance of AMP, QBE, Suncorp-Metway, IAG and AXA has been stunningly good in the face of the offshore insurance sector share price meltdowns. As we have learned from banks, global trends come to Australia with a lag and I'd be very careful in Australian insurance stocks that now look expensive globally and cum derating. Shorting bans do not stop deratings. I'd be lightening Australian insurance sector exposure ahead of the reporting season.

Qantas: Arm doors and cross check

It was interesting to see this week the chief financial officer of British Airways (BA) confirming "the position that the airline faces is much more serious than after the events of September 11, and the impact is likely to be felt for much longer".

BA has warned that it expects to report a loss for the financial year as it came under multiple attack from collapsing premium passenger traffic, cargo volumes and sterling. While BA's fuel bill has fallen, it nowhere near offsets the revenue and margin declines (premium passengers) being experienced or the rising cost of airport charges (expressed in weakening sterling).

BA's premium traffic is a bloodbath, with December volumes down 12.1%, following a 10.8% fall in November, 9.2% in October and 5.4% in September. You'd have to guess that January premium traffic data would be worse – and remember that it is premium traffic where all airlines make their margins. BA has been particularly hit by a huge reduction in corporate traffic between London and New York as the financial crisis reaches a new level. In a similar fashion, American Airlines’ first quarter bookings are down 4.5% despite capacity being reduced by 8.5%. Delta Air Lines also reported a shocking quarterly loss and saw its shares crumble 20%.

Qantas (QAN) is far from immune to these global aviation sector trends. However, it has to deal with the double trouble of global leisure travel contracting aggressively. Travel agents tell me that outbound leisure bookings from Australia have collapsed with the Australian dollar. There is interest in discounted internal leisure travel, but even outbound economy bookings are becoming rarer. If this feedback is accurate, Qantas analysts are over-estimating traffic and yields for the six months to June, making solid downgrades to consensus earnings and dividends likely.

Poor old Qantas has a ton of new capacity coming on over the next few years (A380s, 787s) and I just wonder how it is going to fill all these new planes.

I also have concerns about the carrying value of Qantas’s now-ageing fleet and how it will be treated by a tougher auditing community. Qantas’s net tangible asset figure is most likely lower than most analysts claim if you mark the carrying value of the fleet to reflect the likely second-hand value today. Let's just say the "second-hand wide-body jet market" has collapsed; in fact it hardly exists and I think auditors will force the write-down issue with Qantas at the interim result.

"The chicken or the fish?" The right answer is neither for the next six months as Qantas encounters "severe turbulence".

Telstra: No amigos?

While Telstra shares appear inexpensive after the national broadband network miss derating, it does concern me that the management natives are getting a little restless. There is a bit of a mumble in telco circles that there has been some sort of disagreement at Telstra between senior management and the board. Mumbles have a tendency to be accurate.

The somewhat sudden departure of Greg Wynn, seen by all as the chief architect of the company’s transformation (especially related to network and IT), perhaps confirms the view that not everything is right at the Telstra ship. Wynn had strong views about under what circumstances Telstra should participate in the national broadband network (he dismissed separation of the company and sought regulatory certainty to safeguard the business case). The fact he has departed does pour fuel on the speculative fire that the board and management have had some sort of disagreement about the way forward from here.

The very last thing Telstra needs now is widespread management change. However, conspiracy theorists have put to me that “Sol’s CV” has been out for everyone to see for 12 months. These people believe Trujillo basically inadvertently presents his CV at every global telco conference he attends. Telstra is the 16th-largest listed telco in the world but Trujillo gets a lot more global airtime than the 16th-biggest telco chief executive. There is also some theory Trujillo needs to leave Australia before he incurs a bigger income tax bill. I know nothing about the reliability of that story.

I don’t think it would be great if Telstra were left with “no amigos”. Love him or loathe him, Trujillo has turned this giant ship around. But the job isn’t finished, Sol.

Gold, gold, gold

Gold is finally having its day in the sun, making record highs in euros, sterling, Australian dollars and Swiss francs. After being caught in fourth quarter hedge fund deleveraging, gold is starting to respond appropriately to the greatest financial crisis of our generation. You could argue gold is simply playing catch-up to where it should be, with investors driving the price higher with purchases of gold exchange-traded funds, coins and bars.

Although demand is waning for gold jewellery with the global economy, gold investment is accelerating sharply. It is estimated that investors have purchased 2.5 million ounces of gold exchange-traded funds this year to date, while bullion and coin dealers are reporting record demand. This is understandable as gold (physical) has no counterparty risk and no earnings risk. Sure, gold has no "yield" but nor does anything else nowadays! Government bonds are yielding the lowest rates in history while the risk of credit default of government bonds is actually rising as measured by credit default swap rates. Gold bulls argue that collapsing global cash rates and equity dividends have "slashed the opportunity cost of holding zero-yield gold". That's a fair relative argument, particularly given that "yield-based" investment strategies have been decimated.

Gold is clearly been chased as an alternative to currencies due to the expansion of the balance sheets of the underlying countries backing those currencies. Quantitative easing is the most bullish development for gold in decades and is akin to dropping cash from helicopters. Not only does it increase money supply but also increases the default risk of investment alternatives to gold which itself has no default risk. Gold held in exchange-traded fund contracts now totals more than 40 million ounces for the first time and that is a clear signal that investment demand is increasing. Yes, there is some counterparty risk in gold exchange-traded funds but it is a minimal risk. Inflows into pure gold equity funds have also been very strong, driving global gold equities higher in the past few weeks.

You get the feeling this gold run is in its infancy and could easily get its own self-fulfilling head of steam over the next few months run; premature selling could be painful.

Charlie Aitken, head of institutional dealing at Southern Cross Equities, may have interests in any of the stocks mentioned.