Woolworths produces the goods

Woolworths Limited’s (ASX:WOW) 2012-13 result was one of its best since relisting in 1992, and absolutely supports my decision to hold the stock.

The result was in stark contrast to the sobering outlook statements made by the smaller rival Metcash Limited (ASX:MTS) at its annual general meeting. Clearly 2012-13 was a year where the major non-discretionary retailers – Woolworths and Coles (owned by ASX:WES) – ate up further market shares from the independents.

The market has been overly concerned with the battle between WOW and WES, rather than understanding that MTS as the third player was the one who lost out.

The key features of the WOW result were as follows:

1. Earnings before interest and tax (EBIT) and net profit after tax (NPAT) margins expanded to 6.33% and 3.86%, respectively, both record highs;
2. Before significant nonrecurring items earnings rose 8% to $2,353.9 million;
3. FY13 sales grew 6.1% to $58.5 billion;
4. All divisions performed strongly, with sales in Food, Liquor & Petrol EBIT up 8.7%; New Zealand Supermarkets up 5.2%; BIG W 7.2% higher; and Hotels up 35% on acquisitions; and
5. The full-year dividend was 5.6% higher at 133c fully franked.

Importantly for investors to understand was that WOW achieved these results after losing $138.9 million with Masters, the start-up home improvement chain. Without Masters the result would have been even better. WOW has rallied post the result and is now trading in line with the StocksInValue June 2014 valuation, which is $35.74. So there is no need to consider selling on valuation grounds (refer to Figure 1).

Click to enlarge

Source: StocksInValue.com.au

From an owner perspective, WOW ranks as one of the best stocks to own in Australia. I will cover this a bit later, but my statement is explained by WOW’s inherent ability to invest retained earnings back into the business at high rates of return. Looking forward I expect this to continue and therefore WOW is an essential part of any quality long-term portfolio.

Key points that caught my eye

The major operating division of Food & Liquor produced a good result given the challenging retail conditions, consumer uncertainty and ongoing price deflation. Comparable store sales, EBIT, volumes, market share and floor space all grew. New stores opened at the rate of one per week and served a record 28.4 million customers each week.

Gross margins in food, liquor and petrol rose 30 basis points to 25.1%, buoyed by reduced shrinkage, better promotions and improved buying.

Gross margins across the whole group widened from 26.3% to 26.9% due to cheaper buying, supply chain efficiencies, more effective promotions and reduced shrinkage. Over the last 10 years margins have expanded more than three percentage points. The gains are shared between shareholders and customers in the form of higher returns and lower prices.

WOW’s ability to drive supply chain efficiencies and pass these on to customers increases its competitive appeal in the market and is one of the stock’s attractions.

WOW has the cash flows and balance sheet strength to self-fund its planned expansion. The strategy also includes becoming more competitive with Coles, further supply chain productivity gains, and investment in customer data to gain insights to buying behaviour.

Comparisons across the sector

Over the last five years WOW’s normalised return on equity (including franking credits) has fallen three percentage points from 38% to a still very strong 35%. This has resulted from the competition from a rejuvenated Coles, price deflation and the loss making rollout of Masters.

From an owner perspective this is important because it suggests that WOW can generate high returns from retaining capital. Indeed, WOW has consistently grown earnings and dividends over the last 10 years without the need to raise new equity from shareholders. This is in stark contrast to both WES and MTS.

In the short term I perceive that price deflation remains the main risk to management’s stated current year target profit growth of 4% to 7%.  

However I remain confident that growth will continue despite the subdued retail conditions, which reflect a soft employment market and cost of living pressures. I note WOW management expects an improvement in retail conditions, which may well emanate from the successive cash rate cuts by the Reserve Bank.

Coles, owned by WES, also performed well in FY13 with earnings growth of 13.1% ahead of sales growth of 5.2%. Customer transaction and unit growth offset selling price deflation. Better operational efficiencies and the progressive renewal of the store network also contributed to the result.

In contrast MTS delivered only flat earnings to the end of April due to consumer caution, price deflation, an elevated marketing spend to support sales and losses on Franklins. A $375 million equity raising in mid-2012 diluted returns. Management recently downgraded earnings guidance and the stock has fallen to levels of eight years ago.

The following table (Figure 2) provides key metrics on each of the three stocks. Comparison is complicated by WES’s ownership of non-retail operations.

Clearly, and subject to entry price, I believe that WOW is the best company to own due to its proven ability to reinvest retained earnings, as a superior return on equity delivers the fastest value growth.

To my eye WES remains fully priced and MTS deserves a discount to valuation until it shows an ability to grow.

Figure 2. Woolworths Limited compared with Metcash Limited and Wesfarmers Limited

Source: StocksInValue.com.au

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: 10.12%

Returns since Inception (April 19, 2012): 29.51%

Average Yield: 6.09%

Start Value: $141,128.64

Current Value: $155,408.51

Dividends accrued since June 30, 2013: $879.71