The battle of the retail giants – WOW v WES

It is a battle royale in the supermarket aisles, and so it is on the stock market, where the retail giants slug it out for superiority.

Wesfarmers, led by its super-brands Coles and Bunnings, generates 85% of its earnings from retail – and 90% from consumer-focused business. The company also operates Kmart, Target and Officeworks. Wesfarmers is described as a “diversified conglomerate” – it also has operations in coal mining, agricultural, industrial, medical and industrial gases, and insurance – but effectively it has been a retailer since it bought the Coles Group in 2007.

Wesfarmers Limited (WES)

Source: Yahoo!7 Finance, September 8, 2014

Woolworths, of course, is all retail, based on the eponymous supermarkets business – which is larger than the Coles business – as well as BIG W discount department stores, liquor through BWS and Dan Murphy’s and Masters home hardware stores, which it operates in joint venture with US hardware giant Lowe’s. It also has the hotels business, with its accompanying pokies operation.

Woolworths Limited (WOW)

Source: Yahoo!7 Finance, 8 September 2014

Both businesses tap into the non-discretionary spending of consumers, and are thus considered a reliable, defensive stream of earnings. While this is true at the company level, it does not mean that all of the companies’ respective portfolios perform the same: for example, Target delivered a poor result for Wesfarmers in FY14, with earnings down almost 37%, to $86 million.

Woolworths would wish it had a problem child that earned it $86 million: its major headache is the Masters home hardware operation, which lost $176 million in FY14. Woolworths does not expect Masters to turn a profit before 2017.

The results

Excluding asset sales, Wesfarmers lifted profit by 6.1% in FY14 to $2.39 billion. Coles’ pre-tax earnings were $1.67 billion, up 9.1%, while revenue for Australia’s second-largest supermarket rose 4.5% to $37.4 billion. Officeworks’ earnings were up 10.8% to $103 million; Bunnings’ earnings rose 8.3% to $979 million, while Kmart’s profit was up 6.4% to $366 million.

For its part, Woolworths lifted group sales by 4.7% to $60.8 billion, and net profit by 8.5% to $2.45 billion. A 7.2% rise in normalised earnings from its food, liquor and petrol operations drove the result: liquor sales rose 4.6% to $7.4 billion, while hotels delivered a further $1.47 billion, up 2.2%. General Merchandise (Big W) disappointed, with earnings falling by 20% in FY14.

Wesfarmers has shaded Woolworths as an investment in recent years. According to the Stock Doctor database, Wesfarmers has generated a total return (capital gain plus dividends) of 15.8% in the past 12 months. Over the last three years, it has delivered 20% a year; over five years, 17.7% a year. For Woolworths, the 12-month return is 6.8%; the three-year return is 17.9% a year; and the five-year return is 9.3% a year.

When it comes to the FY14 result, brokers were mostly under-whelmed by Woolworths. Merrill Lynch was disappointed with supermarkets outside Australia; while Macquarie felt that Food & Liquor earnings and volumes were both weaker than it expected, and fell short of Coles’ equivalent metrics. JP Morgan analysts were also concerned about the slowdown in Food & Liquor LFL sales growth and about the risk that strong EBIT (earnings before interest and tax) margin expansion may not be sustainable.

Problem child

Then there was Masters. Broker Citi said losses for home improvement were larger than expected and that break-even was now further away. Citi said investors should recognise the $2.6 billion in capital that was “at risk” in the business. However, Deutsche Bank was pleased with Woollies’ result, and suggested that the “robust” earnings growth expectations for Masters were to some extent underpinned.

Looking at Wesfarmers, broker UBS felt growth was slowing for Coles, but it welcomed the decision to buy Pacific Brands’ workwear division (mostly made up of Yakka) for $180 million. UBS thought this business provided a good opportunity for Wesfarmers, if it can turn the business around. For Macquarie, Wesfarmers’ result was a positive surprise, with all retail businesses reporting results ahead of expectations and the resources businesses delivering a bonus.

But growth expectations from Wesfarmers’ business were mostly weak, and the most enthusiastic that any broker could bring itself to be on the stock in the wake of the FY14 result is neutral – with several ‘underperforms’ and two outright ‘sell’ ratings.

Not such a problem after all

Woolworths, in contrast, has a couple of brokers prepared to say ‘buy’ – Deutsche Bank and UBS – although Citi rates the stock a ‘sell,’ and the rest have ‘under-perform,’ ‘neutral’ or ‘underweight’ ratings.

The consensus of analysts expects Woolworths to earn 205.3 cents a share this financial year, up from 196.4 cents in FY14, and pay a dividend of 144.8 cents a share, up from 137 cents in FY14.

For FY16, the earnings per share (EPS) figure rises to 212.9 cents, while the expected dividend per share (DPS) is 150.1 cents a share.

For Wesfarmers, analysts are looking for EPS of 215.5 cents a share and DPS of 221.5 cents a share for FY15, compared to 209.8 cents and 190 cents respectively for FY14. In FY16, EPS of 235 cents is expected, with a DPS of 229.6 cents a share.

Those expectations have Woolworths, at a share price of $36.31, trading on a FY15 price/earnings (P/E) ratio of 17.7 times earnings, and forecast dividend yield of 4%. For FY16 the prospective P/E is 17.1 times earnings and the projected yield is 4.1%.

Wesfarmers, at a share price of $43.98, is priced on a FY15 P/E ratio of 20.4 times, and 5% expected dividend yield. For FY16, the prospective P/E is 18.7 times and the yield is 5.2%.

WOW or WES?

Wesfarmers is more expensive, but the expected nominal yield – if everything goes as brokers see it – is more than one percentage point better.

Finally, on analysts’ consensus price targets, Woolworths is seen at the moment as being 3.2% above the price target already, while Wesfarmers is also over-valued, to the tune of 4.9%.

It could come down to the battle of the margins, where Coles and Bunnings are increasing their operating margins by lifting sales volumes while they lower product prices, while Woolworths operates on almost world-leading margins, at about 8%.

However, Wesfarmers offers a yield premium, and given Woolworths’ problems with Masters at present, in my opinion, that’s enough to sway a tight comparison Wesfarmers’ way – especially when you throw in the prospect of a $1.1 billion capital return, which the Big West Australian has flagged.

(You can see Charlie Aitken’s contrarian view on Woolworths here).

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.