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Morningstar | Woolworths’ Food Sales Growth Stays Ahead of Its Peer--for Now; FVE Unchanged at AUD 24.50

Narrow-moat-rated Woolworths maintained sales growth momentum in its core Australian food segment, widening the gap with Coles in the third quarter of fiscal 2019. However, we expect this advantage to fade. We estimate Woolworths and Coles to grow sales at similar average rates over the longer term, as they have done in the recent past. On average, Woolworths’ like-for-like sales growth bested Coles’ by only 10 basis points over the past 15 quarters. All the while, Aldi grabbed market share and continues to compete on its low-price proposition. Fortunately for the two market leaders, less-competitive independent grocers, including Metcash’s IGA banner group, acted as the main market share donors for the German discounter.

We estimate Woolworths’ like-for-like sales growth averaged around 3% year to date in fiscal 2019, which would normally imply EBIT margin expansion. However, we expect EBIT margins to contract slightly in fiscal 2019, due to a higher than usual cost of doing business growth. For instance, wage costs increased in January 2019 due to a new enterprise agreement and management’s previously expected tailwind from improved stock loss management is unlikely to materialise. We maintain our fair value estimate of AUD 24.50, and shares screen as significantly overvalued at current prices.

Another structural challenge for Woolworths and Coles is the rampant growth in online food sales, which we estimate barely break even currently. Woolworths’ online food sales increased by a whopping 35%, and online penetration, the amount of total food sales conducted online, stood at close to 4%. We estimate e-commerce contributed over a fourth of the 4.2% adjusted like-for-like food sales growth. We expect online sales to be lower-margin than in-store sales in the foreseeable future, even as the e-commerce platforms gain scale.

Hence, while online sales continue to increase at multiple times the rate of brick-and-mortar sales, we expect the margin-dilutive effect of those sales to become more pronounced.

Assisting Woolworths’ like-for-like food sales growth was the easing of price deflation. Excluding tobacco, fruit, and vegetables, deflation moderated to 1.7% from 2.3% in the second quarter. Deflation abated toward the end of the third quarter, and we understand the exit rate was close to zero, pointing to a possible return of price inflation in the fourth quarter of fiscal 2019.

As we expected, sales growth in the liquor and hotels segments rebounded in the third quarter--slightly more than we expected. Despite strong adjusted like-for like liquor sales growth of 5.9%, management maintains guidance for a reduction in the segment’s EBIT year on year. The main culprit is the industrywide mix shift to relatively lower-margin beer and spirits, away from the more profitable wine category.

The group’s weakest link, Big W, generated solid sales growth, with adjusted like-for-like sales increasing by 7.4%. Yet a return to profitability is unlikely in fiscal 2019, as management reiterated its guided loss of AUD 80 million-AUD 100 million for the discount department store. Growth in higher-margin categories like apparel are lagging overall sales, but we expect these categories to catch up and underpin a return to profits and EBIT margins of 2% long term.

In New Zealand, the Countdown supermarket chain posted a solid result, with adjusted like-for-like sales growth of 3.8% and online sales growth of 43%. Online penetration stands at 6.6% in New Zealand.