The WOW factor – the market is underestimating Woolworths

Chief Investment Officer and founder of Aitken Investment Management
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Being a believer in Peter Lynch theory (the best investment ideas are the ones you see in your day to day life), today I wanted to have a look at Woolworths (WOW), where I have spent a disproportionate amount of time lately buying nappies!

Over the medium-term, WOW has been one of the greatest total return investments available in large cap Australia. But more recently, the retail sector analysts have turned against WOW, with the current BUY/HOLD/SELL recommendation ratio of 4/5/7 being the most negative on WOW I can ever remember. Similarly, the median price target is $32.83, the most bearish median price target versus current share price I can ever remember for WOW.

The table below charts the WOW share price, median analyst price target and BUY/HOLD/SELL recommendations (green/beige/red) since 1998.

That’s why I want to have a look at WOW today because it’s rare that great Australian businesses have such a consensus negative view. History suggests when that occurs contrarians should at least have a look.

A different view

Firstly, I find it somewhat intriguing that the analysts are so negative on WOW when the chart below shows the company consistently beats consensus EPS forecasts and consensus is for EPS to continue to grow out to FY17. In fact, the compound EPS growth forecast for the next four financial years in WOW is 24%. That’s pretty damn good compound EPS growth from the leading player in a defensive industry.

Secondly, WOW just delivered another year of stellar total returns to its 420,000 shareholders, around 50% of whom are Australian “mums and dads”. The total return generated in WOW over FY13 was 30%, made up of 25% share price growth and 5% dividends.

The increase in market cap during the year was $8.5 billion. This was despite dividends of $2.1 billion paid during the financial year (final 2012, interim 2013 and SCA Property Group in-specie distribution). You could argue that the shareholder total return was $10.6 billion for FY13 (before any compounding benefit from reinvesting the dividends during the year). On the opening market cap of $32.5 billion, this equates to a return of around 33%. It’s also worth noting that SCA itself delivered a total return of 17.6%, from December’s IPO date to FY end, as another bonus to WOW shareholders.

The analyst negativity seems to be based around a view on the Masters hardware expansion JV. That view is somewhat justified as the start-up of Masters has been more expensive, slower and less profitable than expected, but, in all reality, it’s a pimple versus WOW’s food and liquor business and this could easily be another situation where a tail is wagging a share price dog.

The competition

Despite a much-improved competitive offer from Coles (WES), WOW’s food and liquor business remains a powerhouse. I see the Woolworths/Coles supermarkets competition as an “effective duopoly”. But by “effective duopoly” I don’t mean constant exercise of pricing power in terms of price rises to customers. In fact quite the opposite, where Coles and Woolworths use their buying power and scale to extract margin/better terms from suppliers (see the recent Coca Cola Amatil result ↓) and then pass part of that on to customers. The customers are winners from what is an “effective duopoly” and you don’t read that in any economics textbook.

The barriers to entry are enormous in terms of capital, logistics and sites. Both players are consistently squeezing more and more out of their suppliers/supply chain to improve the perception of value to their customers, which in turn drives greater market share into the duopoly from smaller competitors, who can’t match their prices/service/range/buying power/loyalty programs etc. WOW reduced average prices by -2.9% in FY13. This average price reduction is smart business for a whole host of reasons, not least of which is consumer regulatory oversight.

I suspect some of the analyst negativity on WOW is driven by the perception that you can’t recommend WOW and WES. It’s a classic broker thing to like one and not the other, or vice versa, to attempt to drive investors to switch between the two. But in this case, I think comparing WOW to WES, and vice versa, is broadly useless. They should be looked at on their own merits, particularly as one is a genuine industrial conglomerate that owns everything from Bunnings to supermarkets and coal mines, and the other is a supermarket and hotel operator with a start-up hardware business.

WOW really is about Australian food and liquor. For the FY13 year, Australian food, liquor and petrol delivered $2.9 billion of the $3.54 billion group EBIT. That’s 84% of group EBIT that grew by 6.7% (normalised) in FY13. The crucial “gross margin” rose 30 basis points to nearly 25%. ROFE (Return on Funds Employed) rose 294 basis points to 76.7%, confirming the Grant O’Brien led management team has done an excellent job tweaking the business model and extracting extra economic value from $46 billion of sales.

Customer numbers increased by 3.6% per week to a weekly average of 28.4 million, with the now 7 million strong Everyday Rewards loyalty scheme driving higher average basket sizes and further customer loyalty.

Australians ‘hate a drink’ and “liquor” is in structural growth mode. Ditto hotels, where the gross margins are huge.

This combined to drive 22.8% EPS growth for WOW in FY13 (4.8% normalised) and a total of $2.2 billion returned to shareholders in various means.

The tail

Regarding Masters, which appears to be the tail currently wagging the share price dog, WOW believes they are at peak start-up losses right now.

Loss leading start-ups that require reasonably large capex have a history of weighing on share prices. However, as the market becomes more comfortable that the start-up losses are peaking and therefore the overall effect on group financial metrics are peaking, it will become more comfortable with the concept and most likely move back to analysing and pricing the WOW food and liquor powerhouse.

Yet despite the larger than anticipated losses at Masters and the effect on group free cash flow, WOW shareholders received the equal largest total distribution from the company. Even after that, the good news is that WOW is sitting on an absolute mountain of franking credits, meaning the likelihood of buybacks and special dividends is high, once the Masters free cash flow and EPS impact reverses. This is a very important point, considering WOW’s retail investor dominated share register. WOW is feeding its loyal retail shareholders “yield”.

In terms of forward guidance, WOW said when announcing its results, “We expect another year of profit growth with FY14 NPAT from continuing operations to increase 4% to 7%.”

WOW is currently cum the 71c fully franked final FY13 dividend. Consensus is for the annual dividend to grow to $1.41 in FY14. That equates to a prospective 13-month yield from WOW of 6.0% fully franked, or 8.6% grossed up. I think that yield support alone is enough to support WOW in the year ahead around current prices, but what interests me more is what P/E the market will pay for this stock.

P/E improvement on the cards

The consensus FY14 EPS forecast is $2.00 (inc Masters’ losses). On the guidance given, that seems about right. Yet P/E has been taken off WOW for the near-term uncertainty of the Masters strategy and I have a feeling it will be added back on, as the market becomes more comfortable that the losses from the strategy have peaked.

I am certainly not in the camp that Masters is going to be some giant ongoing stuff up. I don’t even need it to be a wonderful success, because at the end of the day, WOW really is all about food, liquor and petrol retailing. My view is stability in Masters = P/E being added back to WOW. It’s a pretty simply view that the dog will revert to wagging the share price tail, not vice versa.

In the year ahead, I see WOW P/E heading back to 19 times FY14. That equates to a $38.00 share price. Making a couple of bucks and collecting a couple of bucks in fully franked dividends over the next 13 months in WOW is a nice return from a defensive business.

I think the analysts are too down on WOW at the peak of Masters’ losses and the low point of group P/E. High class, well-run, massive barriers to entry, high sustainable ROE businesses are rarely cheap and I think WOW should be added to portfolios.

Go Australia, Charlie.

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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