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Champagne Charlie toasts WOW

Posted By Charlie Aitken On In Markets,Shares | No Comments

In recent times there has been plenty of financial press and broker debate about Woolworths (WOW). The debate is mostly coming from the negative side, focusing on Masters start-up losses, increased competition from Aldi and the UK experience, which saw incumbents J Sainsbury and Tesco de-rated.

Tesco had another profit warning last week and fell 6%. There have even been questions raised about WOW CEO Grant O’Brien’s overall strategy. This is reflected in the fact that WOW actually has a reasonable open short position of 13.7 million shares ($495 million). That is the first time I can ever remember a short position of any scale in WOW.

Drink and be merry

However, what hadn’t been focused on was WOW’s core Food & Liquor business, which extended its market leadership and expanded operating margins. On every measure, the F&L result for FY14 – the only result that really matters for WOW – was again excellent and confirms what a strong business this is with very high technology, logistics and product sourcing barriers to entry.

I am going to start with some Peter Lynch theory (the best investment ideas you see with our own eyes in everyday life). Woolworths recently opened a brand new supermarket and Dan Murphy’s in Double Bay NSW. The new facility is absolutely superb and also offers two hours free parking for customers, providing relief from over-zealous Woollahra Council parking meter inspectors, who operate in the vicinity.

Let me give you an example why WOW’s F&L revenues and margins are expanding. On Saturday night I popped down to Dan Murphy’s to buy a bottle of champagne. Dan Murphy’s must have known I was coming as smack in my face as I walked in the door was a display of chilled Bollinger for the very low price of $57.00 (exhibit 1.) [1]

If you bought 6 bottles of Bollinger, the price per bottle dropped to $54.00. Of course, as a value investor I took up the offer and bought six. The very attentive/knowledgeable salesman knew a soft target when he saw one and guided me around the shop to other areas I may be interested (i.e. everywhere). Exhibit 2 [2] shows how this ended.

Yes, a quick trip to buy a bottle of champagne ended up with a case of champagne, a case of “low carb” beer, three cases of wine and a bottle of tequila. I don’t even like tequila.

Why did this happen? No, not because I am an alcoholic, but because the range, prices and service at Dan Murphy’s new format store in Double Bay were so damn good. Yes, I spent more money than I intended to, but I left feeling I got a great deal. Isn’t that the goal of retailers? Remember it wasn’t that long ago analysts were sceptical on WOW’s Dan Murphy’s strategy as it rolled out.

WOW liquor group sales growth over the last five years is below.

Masters – borderline irrelevant

So for all the criticism of Masters and concerns about pending supermarket competition, my view is they are missing the point about the dominance and growth options embedded in the WOW F&L offering. These guys are absolutely superb F&L retailers, yet I think there’s more to come in terms of margin enhancement as technology enhances the supply chain.

At the headline level, WOW FY14 group results were rock solid.

But here’s where it gets interesting. Masters start-up losses are a pimple in the scheme of group EBIT. The “home improvement” loss of $169 million is just 4.4% of group EBIT ($3.775 billion). It’s borderline irrelevant.

Click here to view larger image [3]

Now let’s look at that $169 million loss from “home improvement” in terms of group cash flow. Group Operating cash flow was almost $5 billion, while free cash flow was $1.6 billion. Note well at the cash flow level, Masters JV partner Lowes injected $183 million into the business.

Click here to view larger image [4]

Food & Liquor

Now let’s focus on what really matters, the F&L business.

What I focus on here is gross margin up 9 basis points, cost of doing business down 6 basis points, and EBIT to sales margin +15 basis points to nearly 7.00%.

WOW confirmed increases in market share, customer numbers, basket size, items sold and sales per average sqm. They served on average 21.2 million customers a week, up +3.7% on FY13. EBIT grew faster than sales, reflecting improved margins and cost control.

This is where it gets clever and I believe most people don’t understand the long-term margin enhancement power of data mining in the WOW F&L business. WOW now has 7.9 million Everyday Rewards cards on issue, (+10% vs previous corresponding period). WOW is using customer data to refine store layouts and ranges to meet customers evolving needs. This is why the new WOW Double Bay has a cheese room, sushi bar and barista.

WOW is increasingly using customer data to identify new store sites and provide greater access for its customers. For all the hoopla about Aldi’s plans, WOW opened 34 new stores in FY14 and completed 23 refurbishments. WOW now has 931 supermarkets and a monstrous supply chain to match. It also upgraded 67 petrol canopies and forecourts to expand access to diesel, premium fuels and fast flow fuel pumps.

The winners

Customers were the winners, with average price deflation of -3.1%. Promotional campaigns provided another $750 million in savings to customers.

This is all about supply chain management and getting the right fresh products to the right customers in the right location “just in time”. It is not beyond the realms of possibility that with the technology available today that the individual supermarkets can order replenishment in real time (from POS data) from an automated DC that fills a truck and routes it back the most efficient way. In theory, it could all be automated in real time.

I believe WOW can further dial up the efficiencies of supply chain management in project Mercury 2 and through time that will lead to higher operating margins, higher sales growth and better working capital terms and higher profitability.

In terms of guidance WOW guided to FY15 NPAT growth of +4% to 7%. My view is that will prove conservative and another year of +8.5% NPAT growth will be delivered. Aggregate ASX200 NPAT growth is only forecast at +5% in FY15.

Over the next 12 months I think WOW can see a P/E re-rating to within sight of a WES multiple of 19.7x FY15. 19x equates to a WOW share price target of $39.42.

Part of that re-rating will be capital management driven (similar to the WES re-rating this year). WOW has $1.8 billion of franking credits on its balance sheet and with the potential $800 million sale of the hotel properties, the ability to return a good proportion of those excess franking credits to shareholders tax effectively in the year ahead.

WOW is also cum the 72 cents fully franked final dividend, offering a 13-month yield of 6.00% fully franked for anyone who buys the shares in the next three days.

I realise it’s a bit lonely nowadays being a Woolworths believer and a supporter of Grant O’Brien’s strategy, but in retailing terminology, ultra-high quality, long duration cash flow is rarely on sale and I think that is the situation in WOW’s shares today.

WOW is a core portfolio holding for private investors and should be accumulated on dips. I forecast a +15% total return from WOW over the next 13 months, with the added potential off an off-market buyback/franking credit return.

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.

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

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