It is Coles or Woolies?

Co-founder of the Switzer Report
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Key points

  • Net profit after tax for the year from continuing operations at Wesfarmers increased by 8.3% to $2.44 billion, with earnings per share coming in on target at 216.1 cents.
  • Coles led the way contributing 46.1% of earnings, followed by Bunnings (home improvement) at 28.2%.
  • For Woolworths, the next key milestone will come with the appointment of Grant O’Brien’s replacement sometime later this year.

Back on 13 April, in Woolies or Coles, I wrote:

It is pretty line-ball, but if you had to pick just one stock (to maintain some sector exposure), then Wesfarmers gets the nod. Longer term, Woolworths will prove at some stage be an attractive buy. Too early yet. Around $25 to $26, the stock could withstand a dividend cut of 20% and still yield 4.4% (fully franked), so there is an argument that the downside price risk is not that high. The cue will be to wait until the shorters start to reduce their positions. Be patient.

Since I wrote this, Woolworths shares have fallen from $29.56 to close on Friday at $26.37, a fall of 10.79%. Wesfarmers, which owns Coles, has done moderately better – but still a fall of 8.08% from $44.40 per share in April to $40.81 on Friday.

Small comfort, perhaps.

With Wesfarmers reporting last Thursday, and the shorters active in Woolworths, is this still the way to play the consumer staples sector?

A solid year for Wesfarmers

Net profit after tax for the year from continuing operations increased by 8.3% to $2.44 billion, with earnings per share coming in bang on target at 216.1 cents. Coles led the way, contributing 46.1% of earnings, followed by Bunnings (home improvement) at 28.2%. The industrial parts of the Wesfarmers conglomerate – Coal, Industrial & Safety and Chemicals, Energy and Fertiliser -contributed just 9.1%.

20150824 - wesfarmers pie

Importantly, Coles continued to beat Woolworths in the supermarket wars, a feat it has achieved every quarter since 2010. Comparable same store sales growth in food and liquor rose by 3.9% over 2014/15, and ticked up to 4.0% in the fourth quarter. By comparison, Woolworth’s reported a decline of 0.7% in comparable store sales in food and liquor for the first 10 weeks of the fourth quarter.

Bunnings, Kmart and Officeworks starred. Bunnings grew comparable store sales at 8.8%, increased EBIT by 11.1%, and returned a company leading 33.5% on capital employed. Kmart grew EBIT by 18%, while improving its return on capital to 32.9%.

Coles, which uses about 57% of the group’s capital, increased its return from 10.3% in FY 14 to 11.0% in FY 15. In the right direction, but still more work to do here.

20150824 - return on capital

But it is not all plain sailing at Wesfarmers. Challenges include Target, where a transformation program is underway but sales momentum is slow (zero growth in sales in the fourth quarter), the liquor division of Coles, and in the industrials part of the conglomerate. Lower commodity prices and reduced customer project activity resulted in a tough sales environment, and it is expected to remain challenging in the near term.

For shareholders, Wesfarmers increased its final dividend to $1.11 per share, taking the full year ordinary dividend to $2.00 per share – an increase of 5.3%.

The Woolworths play book

Woolworths is due to report its full year result on Friday. It provided updated guidance to the market on 17 June, which pointed to zero growth in full year NPAT at around $2.45 billion, and a second half NPAT approximately 5.5% lower than the corresponding half in FY14. Given its form to date, and with no real incentive with the outgoing CEO to be heroic, it is unlikely to surprise on the upside.

The shorters remain short and aren’t ready to give up yet. According to the latest ASIC figures, 8.24% of Woolworths’ ordinary shares are short sold, worth a staggering $2.6 billion. Wesfarmers, by comparison, only has 2.26% of its shares short sold.

For Woolworths, the next key milestone will come with the appointment of Grant O’Brien’s replacement sometime later this year. The new CEO faces a number of strategic challenges, and the playbook might be something like this:

  • A big write down within a few months of taking over. Potentially, the closure of the Masters home improvement business;
  • The sale/spin-off of the struggling Big W division (aka Dick Smith, which was once owned by Woolworths before being sold to private equity and then floated on the ASX); and
  • A new game plan to take on Coles, Aldi, IGA and potentially Lidl. The supermarket wars may yet get a lot more hostile.
    With this yet to play out, my sense is that it is too early to jump on board Woolworths for the ride.

The brokers

The brokers largely agree. Woolworths remains disliked, while Wesfarmers is marginally in favour. According to FN Arena, sentiment for Wesfarmers is +0.1 (scale -1.0 most negative, +1.0 most positive), compared to Woolworths sentiment rating of -0.6.

20150824 - brokers

Source: FN Arena. Prices as at COB 21 August, 2015

Wesfarmers is trading at a premium to Woolworths. Comparing FY16 PEs, Wesfarmers is trading at a multiple of 17.8, while Woolworths is trading at 15.2. The brokers also see a little more value in Wesfarmers, with its share price 3.4% below the consensus target price.

Bottom line

I don’t think much has changed since April. While it is a pretty line ball call, there isn’t any reason yet to back Woolworths and conversely, most parts of the Wesfarmers business are performing strongly.

At some stage, Woolworths will be in buy territory. When the shorters start to cover, or the new CEO makes some of the changes foreshadowed above, these may be the cues to go long. Be patient.

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.

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