EUR 850.00 For Business Accounts Only

Morningstar | Woolworths’ Weak Earnings Growth Doesn’t Justify Its High P/E Multiple. AUD 24.50 Unchanged

Narrow-moat Woolworths Group delivered a weak result across all noncore business, with all of them posting a decline in operating profit--or in the case of Big W continued losses--in the first half of fiscal 2019. In line with our thesis, a material profitability expansion in the core Australian food business proved evasive, with EBIT margins increasing by a mere 8 basis points in the half. We were surprised by a short-term slow-down in the liquor and hotels segments’ sales growth and EBIT margins, together accounting for 18% of the group’s operating profits, although we expect these segments to rebound. In all, our long-term forecasts for the business are largely unchanged, and our fair value estimate of AUD 24.50 stands.

Australian groceries account for almost two thirds of the group’s sales and operating profit. The current share price of AUD 28.69 implies a 50-basis point margin expansion to 5.2% for Woolworths’ food segment. We continue to view this as an unlikely outcome given the raft of cyclical, but most notably ongoing structural challenges, which we expect to drive EBIT margins lower. Our forecast of 4.5% food EBIT margins in full fiscal year 2019 is unchanged, equating to a year-on-year decrease of 20 basis points, with higher wages weighing on second-half profitability.

We expect several structural challenges to drive down long-run profitability. For one, the ongoing strong growth in online food sales at close to 30%--in line with Coles--is increasingly EBIT margin dilutive. Further, we expect price cutting to be a continuing feature of the Australian food retailing industry, at least in the near term. Woolworths is grappling with intense competition from its key competitor Coles, along with Aldi, and soon Kaufland, in the discount channel, and online from Amazon. We anticipate cost efficiencies generated by both Woolworths and Coles to be mostly passed on to customers. Supporting our view, Woolworths dropped average food prices by 1% in the half.

As a result, we see EBIT margins constrained at 4% long term. Despite the 5% decline in share prices following the result, at a P/E of 22, Woolworths continues to screen as overvalued. For comparison, our intrinsic assessment equates to a P/E 19 for Woolworths and peer Coles currently trades on a P/E of 17. Were Woolworths to successfully maintain its market share of the grocery market while keeping food EBIT margins steady at fiscal 2018 levels of 4.7%, our DCF would increase by 9% to AUD 26.75—still short of the current price.

A key downside risk to our near-term estimates for Woolworths Group is a poorer than expected trading environment, which could be triggered by a downturn in economic growth in Australia, or ongoing softness in residential real estate. Moreover, for the Australian food segment the impact could be longer lasting than for other businesses. We would anticipate consumers to flock to discounters such as Aldi and Kaufland in a downturn, and those shoppers could then prove difficult to win back for the full-service supermarket chains when the macro environment improves.

For now, we have left our sales growth estimates--on a 52-week basis--for the Australian food segment unchanged at 2.7%. In the first half, we estimate headlines sales grew by 2.5% after adjusting for New Year’s Eve. Over the next decade, we forecast Woolworths to maintain its market share and grow Australian grocery sales by 4% on average.

For liquor, New Zealand food and hotels, we trimmed our sales growth expectations in line with the adjusted half-year sales growth figures of 2.5%, 1.9% and 0.5%. We expect the Australian liquor retailing market to rebound from growth of only 1.3% in the half to 4% over the following five years, fuelled by population growth and price inflation. The hotel segment cycled strong sales growth in the previous corresponding period, which was driven by a broad offering of televised events. Our long-term sales growth forecast of 2% per year for the pubs business is unchanged.

Capital management is on the horizon, with the return of AUD 1.7 billion in funds to shareholders following the sale of the petrol business in March 2019. Management mentioned an off-market buy back as a possibility. At current share prices, a buy back would be value-dilutive to our fair value estimate.

The weakest link remained the Big W department store chain. Our forecast of a significant rationalisation of Big W’s footprint is unchanged. We expect some 34% of the current stores to close over the next decade. Management announced it is reviewing the discount department store’s network and will update the market in the next four to six weeks. For further detail on our thesis on this sector, please refer to our report “Australian Department Stores Are Going Out of Fashion,” published Dec. 7, 2017.