Woolworths shareholders have been doing it tough. In the year to March, the share price fell from $35.72 to $29.49. Adding back dividends, this led to a total return of -13.55%. Compared to the S&P/ASX 200 index, which returned 14.13%, Woolworths underperformed by almost 28%.

Wesfarmers, the company that owns Coles, Kmart, Target and Bunnings, faired a little better. Its shares rose over this period from $41.08 to $43.96, which with dividends generated a total return of 11.98% – still less than the index.

To be fair on Woolworths, most of the fall in share price has happened over the last five months, as ongoing concern about sales momentum and continuing losses in the Masters homeware business led many analysts to turn decidedly bearish on the company. Further, investors have been looking at the rout in the share price of UK retailers Tesco and Sainsbury, where competition from discount retailers Aldi, Costco and Lidl is robust, and wondering whether this could also happen here.

Tesco Plc – Share Price April 2010 to April 2015

Source: Bloomberg

Before turning back to the question of Woolies or Coles, let’s look at what is happening in each of these companies.

Woolies struggles

Woolworths continues to lose the war in its key Australian supermarket business to Coles, Aldi and the others. Market share is slipping, and sales growth in stagnant. Comparable store sales growth for the 1st quarter (compared with the same quarter last year) was up by only 2.1%, and in the 2nd quarter ending 4 January 2015, by a very miserable 1.2%. By comparison, Coles grew comparable store sales of food and liquor by 4.3% in the 1st quarter and 4.0% for the 2nd quarter.

The worrying point is that the gap is accelerating. Commenting on its sales performance, Woolworths went close to acknowledging a couple of own goals.

‘While our “Cheap Cheap” campaign has been well received by customers, our promotional programs were not as successful as we expected and we did not see the improvement in price perception we anticipated during the quarter. We should have also invested more into in-store service during the critical Christmas trading period”.

Next, there are the ongoing problems with the Masters home improvement business. Losses increased from $71.9 million in the first half FY14 to $112.2 million in first half FY15. While this loss and Masters sales growth of 28.5% were broadly in line with expectations, there doesn’t seem to be any near term path to profitability.

Finally, there is Big W. A key strategic project for Woolworths, the turnaround of the struggling general merchandiser continues. EBIT before significant items fell by 9.0% to $109.7 million, as comparable store sales fell by 5.4% for the half year (6.5% in the second quarter). Despite the sales decline, there has been an increase in gross margin and the second quarter is said to show improving profitability.

The biggest concern, however, remains the long-term risk of an erosion in margin and decline in profitability from any “price war” in the supermarket business. Woolworths margin (EBIT to sales) in Australian food, liquor and petrol is high by international standards at 7.43%, and compares to Coles food and liquor margin of just 5.3%. With annual sales in Woolworth’s food, liquor, and petrol division of $50 billion – a 0.50% reduction in margin means a $250 million hit to the bottom line – a 1% reduction is worth $500 million.

Wesfarmers is more than just Coles

While Coles is the leading contributor to Wesfarmer’s earnings (42%), the other retailing businesses (Bunnings, Officeworks, Kmart and Target) contribute a further 49%. The last elements of the Wesfarmers conglomerate – Coal, Industrial & Safety and Chemicals, Energy and Fertiliser contribute just 9%. In terms of capital employed, these latter three divisions consume about 15% of Wesfarmer’s capital.

Although Bunnings, Officeworks and Kmart are on fire, the Wesfarmers conglomerate is not without its challenges. Target continues to disappoint. Comparable store sales growth was flat in the second quarter and fell by 1.0% over the half year. Divisional EBIT at $70 million for the December half year was unchanged from the previous corresponding period, representing a deplorable return on capital of just 3.2%.

The Coles business is also not yet starring in the return on capital metric. It has improved to 10.6% in CY2014 from 10.0% in CY2013, although this is a long way short of Bunnings at 31.6%. And while Coles clearly has the sales momentum over Woolworths in the food area, Coles Liquor has been struggling.

The brokers

The brokers don’t like either company at the moment, with Wesfarmers a little less disliked. According to FN Arena, sentiment for Wesfarmers is -0.4 (scale -1.0 most negative, +1.0 most positive), compared to Woolworths’ sentiment rating of -0.6. Source: FN Arena, prices as at COB 10 April 2015

Wesfarmers is trading at a premium to Woolworths. EBIT from continuing operations grew at 5.9% at Wesfarmers in the most recent half year, compared to normalised growth of 4.0% at Woolworths. With an active capital management strategy in place, this translated to EPS (earnings per share) growth at Wesfarmers of 9.6% compared to 4.0% at Woolworths. In part response to this, the market has Wesfarmers trading at a FY16 PE of 18.7 compared to 15.1 for Woolworths – an effective premium of 24%.

Bottom Line

Can Wesfarmers substantiate a pricing premium of 24%? It certainly has the sales momentum with Coles, a powering home improvement division, and doesn’t appear as vulnerable as Woolworths to a price war. Moreover, the analysts haven’t lost faith in the company.

And if you are a believer in “follow the money”, then there is only one way to go. According to the latest ASIC figures, the short position in Woolworths is now out to 91 million shares (or 7.21% of the total number of ordinary shares). This is a staggering position for a ‘top 10’ company –worth about $2.6bn – and compares with 9 million shares (0.77%) in Wesfarmers worth about $0.4bn.

The shorters don’t always get it right, however they are a powerful force to bet against. In the short term, both stocks will lag the broader market if it moves higher. 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 to be an attractive buy but it’s 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 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.

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.