Face off: Wesfarmers vs Woolworths

Financial journalist
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The Ws would be well-represented in many self-managed super funds (SMSFs) – the likes of Westpac, Westfield, Wesfarmers and Woolworths are stalwarts of the sector – all, coincidentally enough, for the recurring nature of their earnings streams and the strong dividend yields that flow from this.

Because they both own retail businesses, Wesfarmers (WES) and Woolworths (WOW) often get compared to each other, in what is often billed as ‘which one should you hold?’

Comparing operations

All that Woolworths does is retail – but it does that very well. The business is based of course on the eponymous supermarkets business, as well as BIG W discount department stores, consumer electronics through Powerhouse and Tandy (the company sold its 325-store Dick Smith chain last month), fuel through the Woolworths/Caltex alliance, liquor through BWS and Dan Murphy’s, and home improvements through Home Timber & Hardware, Thrifty-Link Hardware and Plants Plus Garden Centres. In 2011 Woolworths opened the Masters hardware stores venture with US hardware giant Lowe’s.

Wesfarmers is usually described as a diversified conglomerate – a throwback to the 1980s – but effectively, it has been a retailer since it bought the Coles Group in 2007. It is an adversarial portfolio to Woolworths, operating Coles, Coles Express, Bunnings, Officeworks, Target and Kmart. The retail operations are the backbone of the group: earnings from retail represented 86% of group sales in 2011/12, and 79% of group earnings before interest and tax (EBIT).

It is difficult to imagine Wesfarmers without Coles, but the purchase – which cost $22 billion – has not been without pain for shareholders. Wesfarmers ran headlong into the Global Financial Crisis (GFC), and could not borrow to pay for the leveraged deal to the extent it had planned; it was forced to triple the shares on issue to pay more of the transaction price in equity. Not only were shareholders diluted, they watched as the shares halved in price in 2008, and the dividend fell from $2.25 a share in 2006/07 to $1.50 in 2010/11, before rising to $1.65 in 2011/12.

In contrast, Woolworths held up much better in share price and dividend terms during the GFC, with a payout of 74 cents a share in 2006-07 increasing steadily to $1.22 in 2010-11.

Both Wesfarmers and Woolworths are well-managed companies, with highly regarded management teams led by Richard Goyder and Grant O’Brien. Each business is a powerful generator of cash, and pays a dividend yield above the market average. More importantly, the premium nature of this yield appears to be sustainable – which is why the pair of retailing Ws are so popular in SMSF-land.

Woolworths

Let’s look at Woolworths first. Based on the consensus of eight brokers’ forecasts (collated by FN Arena), Woolies is expected to pay a dividend of $1.33 for 2012/13, rising to $1.39 in 2013/14. At $29.22, that puts Woolworths on a prospective yield of 4.55% in 2012/13 and 4.76% in 2013/14.

As always, these nominal yields have to be considered in light of the tax concessions of the super environment in general, and SMSFs in particular. The partial refund of franking credits to a SMSF in accumulation mode, paying 15% tax, and the full cash refund of franking credits to a SMSF that has switched to pension-paying mode, augment the effective yields substantially.

The upshot is that while you hold Woolworths in an SMSF in accumulation phase, that 2012/13 yield becomes effectively 5.51%; and the 2013/14 yield becomes 5.77%.

If your SMSF has switched to pension-paying mode, and is untaxed, the 2012/13 yield becomes the equivalent of 6.47%, and the 2013/14 yield swells to 6.77%.

Woolworths (WOW) stock performance

Wesfarmers

Wesfarmers is expected by the market to pay $1.79 in 2012/13, and $1.94 in 2013/14. At $35.10, that has Wesfarmers paying a nominal prospective yield of 5.10% in 2012/13 and 5.53% in 2013/14.

Looking at it from the perspective of an SMSF in accumulation mode, the equivalent yields become 6.18% and 6.70%. For a fund paying a pension, Wesfarmers is effectively expected to generate 7.26% in 2012/13 and 7.87% in 2013/14.

Falling rates

The backdrop against which to assess these yields is that official interest rates are poised to come down. From 3.25% at present, market consensus expects the Reserve Bank of Australia to cut interest rates again in November: at 3%, the rate would only be 0.11% above the record low, which dates from 1960!

No wonder that stocks of the calibre of Woolworths and Wesfarmers are staples of income portfolios.

But when looking at yields, investors can get too caught up in working from the current share price, when what really matters to them is the price at which they bought the shares. The yield to them is the yield of the dividend stream on their purchase price.

For this reason, I like to look at what shares currently yield on what people might reasonably have paid for the shares in the past.

Ten years ago, you could have bought Woolworths for about $8. Had you done so, your expected yield for 2012/13 works out to 16.62%. In your SMSF, paying 15%, that is the equivalent of 20.14%; in pension mode, those ten-year-old Woolworths shares are throwing off an effective yield of 23.65%.

Let’s do the same for Wesfarmers. You bought the shares ten years ago at $17.35 – we’ll just ignore, for the moment, the fact that you saw them halve in the GFC. The expected dividend of $1.79 in 2012/13 comes to 10.32% nominal. In accumulation mode in your SMSF, the shares are generating the equivalent of 12.51%; in pension mode, that rises to 14.68%.

The bottom line

These are high-quality companies, great humming cash generators, and if you look at them on price/earnings (P/E) grounds, they are expensive to buy right now. But in a SMSF, the yield case for either is compelling. Arguably the lower yield of Wesfarmers is compensated for by the fact that it also offers resources exposure, plus a smattering of other exposures; but Woolworths’ status as one of the premier defensive exposures in the economy is well-justified.

There would have to be a profound change in Australians’ shopping habits before Woolies’ cashflows came under pressure. The yield premium tips Woolworths over the line in this comparison.

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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