We recently researched Woolworths (ASX:WOW) in The Dynamic Investor. The progressive decline in the share price since the release of full-year results in August prompted us to consider whether the risk/reward ratio was more balanced. On the one hand, the recent quarterly report reinforced expectations for strong sales and margin trends to continue over the short term at least. However, are challenges in other businesses detracting from WOW’s investment appeal?
Woolworths 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
Positive Sales Growth Trends
In late October, Woolworths released sales figures for the 14 weeks to 1 October 2023 (1Q24). The Australian Food division reported Like-for-Like (LFL) sales growth of +5.5% for 1Q24, which was broadly in line with consensus expectations.
Volume growth during the period was supported by an increased demand in fruit & vegetables, and meat products, as these categories were in deflation over 1Q24. The Company noted that these categories have significant demand elasticity as price shifts. In addition, consumer behaviour remains broadly stable compared to the prior quarter, with continued trading down into private label products.
In the trading update accompanying the 1Q24 release, WOW commented that sales trends in the 2Q24 period to date have been broadly in line with 1Q24. However, the trading environment remains uncertain and value-for-money remains a key focus for customers ahead of the important Christmas and holiday trading period.
Quarterly LFL sales growth over the course of FY24 to be supported by volumes growth despite a moderation in the average rate of food inflation. The key factors underpinning this expectation are:
i. Return to eating at home, which is driving a boost to total in-home consumption. WOW said part of the volume growth was driven by two factors. Firstly, consumer preference for quick-service restaurants is easing. Secondly, more younger singles and couples are returning to physical stores and/or purchasing via the online channels.
ii. Net migration continues to lift in 2024, which should see population growth re-accelerate.
Margin Supported by Several Factors
In FY23, WOW reported Gross Profit Margin (GPM) expansion of 76 basis points to 28.1% for the Australian Food division. This result compares with a 36 basis point decline in GPM for Coles. The outperformance on the basis of GPM reflects WOW’s faster implementation of Scan Assist technology, as well as significantly better stock loss compared to Coles
Importantly, the improvement in GPM underpinned an expansion in EBIT margin in FY23, with several factors likely to support EBIT margin over FY24-26. The include:
- Improved product mix. This is being achieved via easing tobacco sales, rising own brand, as well as greater volumes in fruit & vegetables.
- Ongoing cost-out programs; via a more stable supply chain and labour/productivity initiatives. WOW’s labour rostering initiative enables WOW to invest labour hours at times when they are most needed. In turn, this helps drive customer satisfaction and ultimately sales. In addition, it partially offsets the impact from material wage increases, as well as inflationary pressure in energy and transport costs. The Company noted at the FY23 results release that supply chains had improved to a point where stock availability was back to pre-COVID levels. The normalisation of supply chains and stock availability should also enable WOW even further improve labour productivity.
- The establishment of alternative revenue sources in digital & media. These avenues continue to outpace grocery revenue growth. Further, they are estimated to generate margins materially above that for core grocery operations.
Challenges in NZ and Big W
LFL sales for the NZ Food division increased 2.6%, which was below expectations for around +3.5% growth and despite food inflation of 6.3%. The Company noted that there was a slowing trend throughout 1Q24, due to lower inflation and volume declines driven by a very challenging economic environment and competitive landscape, as well as reduced online sales. In particular, consumer spending is weak, wage growth is high and smaller grocery players including The Warehouse and Costco are taking share.
Divisional earnings expected to remain challenged over the medium term due to several factors. These include ongoing competitive pressures, further investment in price and continued higher wage pressure. There is potential for the NZ Food division to eventually return to pre-COVID levels. However, a significant recovery in EBIT is not expected until FY26. This is because the earnings uplift from initiatives in pricing, loyalty and store rebranding are likely to be prolonged and come with elevated execution risk.
In relation to Big W, LFL sales growth remains weak. Further, the business appears to be losing market share, most likely to Kmart as a result of the latter’s private label offering.
Woolworths shares are currently trading on a 1-year forward P/E multiple of ~22x, which is below the long-term average of ~25x. In addition, the stock’s 1-year forward P/E is trading at a 3x point premium to Coles, which is below the long-term average premium of 4x. At the time of writing, COL was trading on a 1-year forward P/E multiple of ~19x.
This premium rating is underpinned by several factors. Firstly, the Company’s investment in supply chain, data and alternative revenue sources is market leading. Secondly, WOW is outperforming Coles on key metrics such as GPM and (more recently) LFL sales growth. However, at current levels, we consider that continuing challenges in the NZ Food division and Big W are likely to cap further upside in the shares.
WOW has been trending lower since the June peak. The selling has also picked up pace since mid-October where any rallies are failing to overlap the prior lows – which is a negative sign. At the moment, the risk to WOW is to the downside where we expect it to retest the lows near $32.
Michael Gable is managing director of Fairmont Equities.
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