We recently researched Woolworths Group (ASX:WOW) in The Dynamic Investor. The further decline in the share price since our last review of the Company in November prompted us to consider whether the risk/reward ratio was more balanced. The most recent quarterly report for the three months to 31 March 2024 (3Q24) was, on balance, disappointing. However, has WOW’s investment appeal increased at current levels? Or are there still risks to keep investors on the sidelines?

About Woolworths Group

Woolworths Group is an operator of general merchandise consumer stores and supermarkets in Australia and New Zealand (NZ). The Company’s operations are divided across three divisions: Australian Food, NZ Food and discount department store brand Big W.

Key Fundamental Drivers

Why are Woolworths Supermarkets Underperforming Coles?

For the 3Q24 period, WOW’s Australian Food division reported sales growth of 1.1% on a Like-for-Like (LFL) basis. These figures were well below that reported by Coles Group (ASX:COL) for the same period (LFL sales growth of 4.2%).

The sales differences in 3Q24 between Coles & WOW can partially be explained by Coles’ successful collectables campaign (Pokémon) while WOW had none. There were also issues with availability of fresh produce (which Coles didn’t). WOW has positioned itself as the premium supermarket. This means that while actual trolley prices between Woolworths and Coles are similar, branding matters and is eroding sales at the moment for WOW.

The Company estimates that changes to promotional calendars (by both supermarkets) explains ~2.0-2.5% of its underperformance to Coles for 3Q24. In addition, overall growth is being impacted by weak space growth with only two net new supermarkets opened during the quarter.

Will Sales Growth Improve Into 4Q24 and FY25?

While Coles is likely to continue holding a gap in LFL sales in 4Q24, the gap is expected to narrow as the cyclical factors of availability and collectibles program dissipate. There are several factors underpinning expectations for an improvement in LFL sales performance:

i. Continues momentum in online sales, with WOW growing online (food) at ~18% in 3Q24. In context, WOW has the leading share in the channel (~60%).
ii. Improvement in market volumes, which is supported by factors such as a moderation in eating out and population growth.
iii. More effective promotional spending, to improve WOW’s value perception and to win back market share.
iv. Increased loyalty investment, as WOW continues to roll out new initiatives under its Rewards program.

Other Key Divisions Continue to Struggle

Recent performance for the NZ Food division has been impacted by lower inflation and volume declines. The latter has been driven by a very challenging economic environment and competitive landscape. In particular, consumer spending is weak, wage growth is high and smaller grocery players including The Warehouse and Costco are taking share.

Divisional earnings are expected to remain challenged over the medium term due to several factors, including: i) Competitive pressures, ii) Investment in price to improve value perception with customers, iii) Increased focus by WOW on Own Brand to drive better value for customers and iv) Continued higher wage pressure that is tracking ahead of sales growth.

Big W’s 3Q24 results confirmed that Big W continues to lag Kmart, particularly in the Clothing and Home categories. LFL sales declined by 5.1%. Price perception is likely a key driver for the difference in performance, with Kmart having a well-established value proposition.

Potential for Margin Improvement

EBIT Margin in the Australian Food division is expected to remain largely flat over the medium term. Despite goods inflation slowing, cost inflation across wages, energy, and logistics remains elevated. In addition, WOW is facing cost headwinds from reinvestment in price. This is due to increasing regulatory risks and higher promotional spend in order to regain lost market share.

Having said that, we note two key factors supporting expectations for improved group EBIT margin over FY25-27: i) The establishment of alternative revenue sources in digital & media and ii) Ongoing cost-out programs; via a more stable supply chain and labour/productivity initiatives.

Capital Management Increases Yield Appeal

WOW’s gearing level is presently slightly elevated. However, the potential from an upcoming asset sale will be used to reduce gearing and return capital to shareholders. The Company also has substantial franking credits, so may consider a special dividend or an on-market share buyback.

Fundamental View

Woolworths shares are currently trading on a 1-year forward P/E multiple of ~21x, which is below the long-term average of ~26x. Notwithstanding this, outside of the potential for capital management to be announced at the FY24 results in August, we struggle to see any real catalysts for the shares in the near term. In particular, i) WOW’s LFL sales in Australian Food are likely to continue to lag Coles; ii) There is limited operating leverage for the Australian Food division and at a group level; iii) The poor results and challenging outlook for both Big W and the NZ Food division continue to weigh on sentiment and v) There is increased regulatory scrutiny on the major supermarkets.

Charting View

Woolworths remains in a downtrend. However, it has become a little oversold in the short-term and is therefore finding some buying support near $30. It remains too early to know whether the downtrend is over so the risk is that WOW will either trend sideways from here or head lower towards $28.

 

Michael Gable is managing director of Fairmont Equities.

 

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