With both major retailers reporting full year results last week, a timely question to ask is: should I own Wesfarmers or Woolworths? Or perhaps both? Or perhaps neither?
I think it is fair to say that until the supermarket war ends, both stocks are going to be somewhat growth challenged. And they are not particularly cheap stocks anyhow, so I am starting from the perspective that the consumer staples sector, of which Woolworths and Wesfarmers account for 80%, is a sector to stay underweight in.
Interestingly, both stocks have provided positive returns this year. Wesfarmers has done better overall with a return of 8.72% compared to Woolworths’ 3.42% and the market’s 7.18%. And while the consumer staples sector is broadly on track with the overall market, this has occurred at the same time as the largest sector, financials, is in the doldrums.
I don’t think it is a case of having no exposure to the sector, and from a risk perspective, there is probably not too much downside in having some exposure. But let’s look at the results and see whether there is a strong case for one stock over the other.
Wesfarmers
Wesfarmers net profit of $407m was down 83.3% on the 2015 result. After adjusting for non cash impairments to the carrying value of the Curragh coal mine and Target department store business, the underlying profit after tax was $2,353m. This was down 3.1% on the FY15 result.
More worryingly, the second half was a lot weaker than the first half, and down on the same period last year. Second half underlying NPAT of $960m was down 9.8% on the $1,064m reported in the corresponding half in 2015.
Wesfarmers challenges emanate largely from two divisions. The resources division, which is mainly the Curragh coal mine in Queensland, suffered from the fall in coal prices, weather delays, foreign exchange hedging losses and lower than cost contracted prices to the Stanwell Power Station. Earnings declined from $50m in 2015 to an EBIT loss of $350m in FY 2016. The other business is, of course, Target (now part of the Department Stores division). Earnings declined to a loss of $195m, or an underlying loss of $50m when restructuring costs and provisions of $145m are excluded, compared to EBIT of $90m in 2015.
The Coles supermarket business generated $1,860m or 52.6% of Group EBIT, while home improvement (mainly Bunnings) chipped in with 34.4%. Kmart and Officeworks performed strongly.
In the final quarter of FY16, Coles beat Woolworths for the 28th consecutive time in the sales war. When adjusted for the timing of Easter, comparable store sales in food grew by 3.2%, compared to the same quarter in 2015. Woolworths sales declined by 1.1% in the 4th quarter.
Same stores sales growth
*Adjusted for the timing of Easter
For Coles and Woolworths, food price deflation is increasing, which goes in part to explain why sales growth is stalling. In the 4th quarter, Coles estimated the impact to be worth 2.4% – up from 2.0% in the third quarter and an average of 1.2% in the first half. While there are also other factors at play, such as suppliers competing to provide goods at lower prices and the seasonal impact of fresh food, a major factor in price deflation is the supermarket chains – Coles, Woolworths, Aldi, IGA, Costco etc. – competing aggressively to maintain market share.
Sales at Kmart continued to grow strongly, while Target is still struggling.
Upsides for Wesfarmers include the recently acquired Homebase home improvement business in the UK, a recovery in coal prices helping to drive an improvement in the earnings of the Curragh coal mine, and fixing Target. Given the poor track record that Australian companies have with UK acquisitions, Homebase is also a risk that shareholders need to weigh up. Wesfarmers said that this result included four months of Homebase, and that “repositioning and restructuring” is going to plan. Clearly, it is early days.
Apart from ongoing price deflation in the grocery business, the other main risk for Wesfarmers is that Coles has peaked and that a re-invigorated Woolworths might take away its momentum. Wesfarmers also warned that the outlook for its industrial division, which includes coal mining, industrial and safety, and chemicals, energy and fertilisers remains “challenging”.
Woolworths
Woolworths reported a net loss of $1,235m. This included provisions for the closure of Masters and the write-down of inventory at BigW. After these items are removed, NPAT from continuing operations fell by 39.2% to $1,558m.
In supermarkets, EBIT fell 40.8% to $1,760m, as sales stalled and price competition intensified. Net margin (or EBIT as a proportion of sales) fell from 7.33% to 4.47%.
Woolworths Divisional EBIT
[1]The rebranded Endeavour Drinks, which is the Dan Murphy’s, BWS and online wine brands businesses, was a relative bright spot in the results. Sales grew by 4.7% over the year, leading to an EBIT increase of 3.0%.
Green shoots in the result included a relative improvement in 4th quarter sales performance, with comparable store sales in food at Woolworths only down by 1.1%, compared to the corresponding quarter in 2015, and Big W sales actually increasing by 1.2%. (see Table above). For the first eight weeks of FY 17 ending 21 August, Woolworths said that Australian comparable store food sales increased by 0.3%.
The Brokers and Pricing
The brokers as a group are relatively unenthusiastic about both companies, with price targets below their current stock prices. According to FN Arena, the major brokers are slightly more disposed to Wesfarmers than Woolworths, with sentiment at 0.0 for the former compared to -0.4 for Woolworths (range of -1.0 is most negative, to +1.0 is most positive).
On a multiple basis, they have Wesfarmers trading on a multiple of 18.9 times FY17 earnings and Woolworths on a multiple of 21.3 times FY17 earnings. They forecast a small increase in the Wesfarmers dividend from $1.86 per share to $2.00 per share, and from $0.77 to $0.81 for Woolworths.
Broker Forecasts
[2]
My view
While the green shoots at Woolworths are encouraging, I am not convinced that we are going to see much of an earnings uplift. Sure, if the supermarket war abates a little and price deflation eases, there will be an opportunity to increase margin. However, at a multiple of 21 times FY17 and FY18 earnings, Woolworths is not cheap.
Wesfarmers, on the other hand, seems to be the higher risk proposition. Rewards if the Homebase acquisition and the industrials division, in particular the coal business, is able to recover, but conversely, downsides if these divisions are challenged. It is also not clear whether the fix for Target is working yet. And maybe Coles will have to compete harder on price if the sales momentum switches to Woolworths.
But, Wesfarmers is cheaper on multiple, and current management has the track record to warrant support. And while it is not a wholly reliable guide, the shorters still seem comfortable with their position on Woolworths. According to the latest ASIC figures, 7.95% of Woolworths shares, or 101.6m shares worth almost $2.5bn, are short sold. For Wesfarmers, it is only 1.96%.
In an environment where neither stock appeals that much, I continue to prefer Wesfarmers.
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.