Why you should keep Woolworths in stock

The Woolworths Limited (ASX:WOW) half-year result reported last week was a picture of consistency. The growth in revenue of about 6% was matched by earnings growth of 6%. Dividend growth per share was slightly lower at 5% as a result of increased shares on issue.

The consistency and indeed the predictability of the operating performance was not matched by a consistency in share price performance. Indeed it is amazing to reflect on the share price movements of WOW over the last 12 months. Essentially the shares have traded over a 20% price range and today sit in the mid-range between the low point of $32 and high of $37.

Whilst WOW has a few operating divisions it is important to understand that 85% of profits are generated from the Food and Liquor divisions which include NZ retail outlets. Further, the great bulk of this is generated by food retailing.  Of much less significance is Petrol (3% of profit), General Merchandise (5% of profit) and Hotels (7% of profit). The losses emanating from the Masters rollout detract about 3% from reported profits.

What I perceive from the above is WOW is holding its market food retailing share against Wesfarmers/Coles (ASX:WES). The two majors are essentially slowing eating up the independent competitors with only slight interference from the Aldi and Costco rollouts.

Indeed WOW reported that its actual customers lifted by 3.9% over the period which is faster than the population growth of Australia. That sounds impressive but my enthusiasm is tempered by the observation that WOW opened 38 new Masters Stores, 23 supermarkets and 6 liquor stores.

These store openings exhibit the power of WOW. Of its expected $2 billion of capital expenditure in 2013/14 some $276 million is earmarked for new stores. Then there is $427 million to be directed to refurbishments with a massive $644 million to supply chain improvements and IT system upgrades. New greenfield developments and new Masters stores represent another $650 million of investment. All of this will be done and funded from operating cash flow. Notably debt will hardly rise and dividends will lift.

All of the above is generated from a solid focus on profit margins and cost containment. WOW pointed to a slight lift in gross profit margin (27.04%) and a slight fall in the cost of doing business. This resulted in an EBIT margin of 6.6% which places WOW amongst the highest profit margin food retailers in the world.

Importantly for shareholders to understand is that WOW is maintaining profit growth whilst expensing the losses of the Masters rollout. Thus, the non-Masters businesses are generating profit growth that is somewhat understated by the Masters position. In any case it is all about food retailing and it is here that WOW is a powerhouse. 

As for return on equity (ROE), it is also consistently high. I will show this below (Figure 2) when I look at the forward estimate of value from StocksInValue (SIV). Readers should note that to derive ROE, SIV adjusts profit for non-recurrent items and it adds the benefit of franking credits distributed. The derivation of normalised return on equity (NROE) thus reflects a true return to the owner of a listed company.

Deriving the forward value of Woolworths Limited

As outlined above there was nothing in the WOW half year report that changed the continuing expectation of solid profit growth. The strong reinvestment programme, new store openings, strong financial discipline and leverage to Australia’s population growth, continues to make WOW perfect for holding in our growth portfolio. The only proviso remains that its share price is not excessive when compared to current and future valuations.

The following table (Figure 2) from SIV outlines our current thoughts on value. Today WOW is trading at the SIV assessment of value as at June 2014 ($35.87). Further, based on current market estimates of profit for 2014/15, I can see that a return of at least 10% should be achievable from WOW with a valuation of about $39 in June 2015.

The key inputs to the valuation are NROE and required return (RR). The NROE that has been adopted of 35% is broadly consistent with market expectations of another 6% lift in profit in 2014/15. The RR of 11.9% is conservative given the quality of WOW’s business. However, I am not of a mind to change it as conservatism is an investment trait that will protect investors over a long period.

Therefore, WOW stays firmly in the portfolio with my current accumulation price of about $33.50. Should the senseless volatility of markets continue (and I think it will), then I may consider letting some stock go at the 2015 valuation of towards $39.00.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au

Clime Growth Portfolio Statistics

Return since June 30, 2013: 8.70%

Returns since Inception (April 19, 2012): 27.84%

Average Yield: 5.80%

Start Value: $141,128.64

Current Value: $153,406.82

Dividends accrued since June 30, 2013: $4,398.83