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Morningstar | Woolworths Supermarkets' Sales Growth Decelerates as Competition Reintensifies; FVE Unchanged. See Updated Analyst Note from 20 Aug 2018

We maintain our fair value estimate on narrow-moat-rated Woolworths at AUD 24.50 per share after the company reported results broadly in line with our estimates, and shares screen as overvalued at current prices. The group’s Australian supermarket sales growth came roaring back in fiscal 2017 after significant price cuts; since then, comparable sales growth has outpaced that of archrival Coles throughout fiscal 2018. Unfortunately, competition rarely sleeps for too long.

Coles has been picking up its game, and the successful Little Shop campaign of collectible toys carried its sales momentum into the first quarter of fiscal 2019. Woolworths' like-for-like food sales have been slowing since the second quarter of fiscal 2018, and have hit a 21-month low in the first seven weeks of fiscal 2019. We estimate Woolworths' like-for-like food sales growth currently sits below Coles’ growth rate. The strong supermarket sales growth over the past two years underpinned gradual food EBIT margin expansion, but we expect this trend to reverse in fiscal 2019. We consider Woolworths' stock loss to be at industry-leading levels currently, and the significant cost savings from improving shrinkage from relatively high previous levels are unlikely to be repeated. Also, as sales growth slows, so should operating leverage benefits.

Once Aldi’s relatively high sales growth peters out in 2020, we expect Woolworths and Coles to increase top-line sales in line with the overall Australian food market at 4% on average. However, we expect the ongoing competition for market share among incumbents to remain intense and keep EBIT margins in check. The entry of hypermarket chain Kaufland, if successful, as well as the possibility of Amazon rolling out its Fresh offering, present threats to our base-case scenario of stabilising market shares across the industry and EBIT margins for Woolworths at around 4% in the longer term.

The Australian supermarket segment represent two thirds of Woolworths’ EBIT from continuing operations.

Woolworths reported net profit after tax of AUD 1,724 million, including its petrol business, and operating profit from ongoing operations of AUD 2,684 million, excluding central overheads. This compares with our estimates of AUD 1,751 million and AUD 2,648 million, respectively.

Management intends to update the market on the fate of its petrol business before Christmas 2018, and is driving a dual process, with the most likely outcome a trade sales or initial public offering. In December 2017, the Australian Competition and Consumer Commission opposed BP in acquiring the business for AUD 1.8 billion. We believe even an attractive deal is unlikely to be material to our fair value estimate, given the relatively small size of the petrol business relative to Woolworths’ AUD 39 billion market capitalisation. However, a divestment could crystallise value and open the door to further capital management, including returning funds to shareholders through share buybacks or special dividends. On the back of the recently announced Caltex transaction, which entails a AUD 50 million payment to Woolworths, and strong cash conversion, the board declared a special dividend of AUD 0.10 with the results. The ordinary dividend of AUD 0.93, fully franked, was slightly less than our AUD 0.95 estimate. We forecast a payout ratio of 75%, up from 70% previously, and an ordinary dividend of AUD 1.07 in fiscal 2019.

The Australian supermarkets segment increased sales by 4.3% in fiscal 2018, with comparable sales slowing to an Easter-adjusted 3.1% in the fourth quarter from 5.0% and 4.0% in the second and third quarter, respectively. Like-for-like sales decelerated to 1.3% in the first seven weeks of fiscal 2019. Competitor Coles’ like-for-like food sales were 1.8% in the fourth quarter of fiscal 2018. We expect Woolworths’ sales to rebound slightly from current levels, and forecast total sales growth of 4.4% for the segment, including an additional trading week. Food EBIT margins of 4.7% were ahead of our 4.5% estimate in fiscal 2018, and food EBIT was 3% higher than our forecast. We expect EBIT margins to decline by 20 basis points in fiscal 2019, driven by slower sales growth, higher wage costs, and ongoing investments in digital and service.

The group’s second-largest business, Endeavour Drinks, generated EBIT of AUD 516 million and accounted for 19% of the group’s operating profits from ongoing operations. This was 2% lower than our estimate of AUD 529 million, and was struck on a lower-than-expected EBIT margin of 6.2%. Total sales grew by 4.5%, or 3.6% on a comparable basis, in line with our total sales forecast of 4.5%.

In New Zealand, both total and comparable supermarket sales grew by 3.4% in local-currency terms, but by just 0.9% in Australian dollars. This was in line with our forecast total sales growth of 3.5%, denominated in New Zealand dollars. The segment's EBIT represented 10% of the group’s EBIT in 2018, down from a 12% contribution, after decreasing by 10% to AUD 262 million as the cost of doing business increased. Still, this was slightly better than our forecast of AUD 255 million.