On 31 October shares of Australian mega-retailer Woolworth’s Limited (WOW) closed at $36 per share. Within two days the share price fell to $33.30 following the release of First Quarter financial results showing a 3% increase in total sales. Not great, but not so bad either, so what was the problem?  

Woolworths is locked in an epic price war and strategic market share battle with rival Coles – owned by conglomerate Wesfarmers Limited (WES).  In short, Woolworth’s results paled in comparison with the latest release from Wesfarmers.  In the all-important food and liquor segment Coles’ sales increased 5.8% compared to just 3.9% for Woolies.  In addition comparable store sales increases at Coles were more than double those of Woolworth’s – a 4.3% rise at Coles compared to a 2.1% jump at Woolworth’s. Comparable store sales are the industry’s way of eliminating growth from new store openings by limiting reporting to sales from stores open for comparable periods, usually more than a fiscal year.

Woolworth’s share price has recovered somewhat but is still negative year over year.  The company pays a fully franked dividend with a current yield of 4.1%.  What’s more, its industry sector, Food & Staples Retailing, is a defensive stalwart in times of economic downturn or uncertainty.  You know the saying – people have to eat. 

Woolworth’s represents one of Australia’s most iconic brands and the stock is considered by many to be one of the bluest of ASX blue chips. So is WOW a Buy right now, or you should you Wait and See, or perhaps even sell?

Is rival Wesfarmers a better play? 

And what about the third largest Food & Staples company on the ASX – wholesale distributor Metcash Limited (MTS)?

First let’s look at some current and historical measures for the three companies.  Here is the table, listed by market cap.

Company

(CODE)

Market Cap

Share Price

52 Week % Change

Current Dividend Yield

5 Year Average Dividend Growth

5 Year Average Earnings Growth

5 Year Share Price Change

5 Year Total Shareholder Return

Wesfarmers

(WES)

$ 50.48b

$44.04

-1%

4.5%

12.5%

2.6%

+62%

13.2%

Woolworth’s

(WOW)

$42.33b

$34.35

-1%

4.1%

5.7%

5.5%

+20%

8.6%

Metcash

(MTS)

$2.56b

 

$2.80

-15%

5.9%

-5.1%

-0.8%

-38%

-3.4%

 

If you were to make an investing decision strictly on historical performance measures like these, which company would you choose?  Metcash appears out of the question and Wesfarmers showed the best rate of return over five years.  However, a closer look shows the total average returns shareholders of Wesfarmers received appear to be the result of higher dividends and rising share price, not earnings.  Woolworth’s five year average earnings growth was twice that of Wesfarmers.  Let’s see what analysts think.  The following table shows analyst recommendations for the three along with a consensus rating.  Here is the table.

Company

(Analyst Consensus)

 

BUY

OVERWEIGHT

HOLD

UNDERWEIGHT

SELL

Wesfarmers

(HOLD)

 

4

0

6

2

4

Woolworth’s

(HOLD)

 

6

1

4

2

5

Metcash

(UNDERWEIGHT)

 

0

2

2

0

4

 

WES and WOW together have somewhere between 70% and 80% of Australia’s $82 billion dollar grocery business, with the differences in share stemming from how analysts include ancillary businesses like liquor distribution and petrol.  A Roy Morgan Research report from February of 2014 stated Woolworths stood at 39% market share with Coles controlling 33.5%.  The following graph from Roy Morgan shows the complete breakdown.

Aldi entered the Australian market around 2000 and has bumped IGA from the third spot and is continuing to grow.  Metcash is the wholesale distributor for the IGA chain of independent grocers.  Coles was losing market share when Wesfarmers stepped in and purchased the company in 2007 but upped its share in the midst of a price war involving Coles, Woolworths, and Aldi.  Coles “Down Down” ad campaign to promote its lower prices forced Woolies and Aldi to respond.  While consumers may have benefited, the ongoing war is increasing pressure on independent grocers supplied by Metcash.

Both Wesfarmers and Woolworths have extended their reach far beyond the grocery shelf.  In its FY 2014 Full Year Results presentation Wesfarmers reported Earnings before Interest and Taxes (EBIT) from its retailing operations of $3.2 billion.  From that total, $1.6 billion came from Coles and $979 million came from the company’s home improvement Bunnings Hardware stores.  The remaining divisions – chemicals and fertiliser, coal, insurance, and industrial and safety supplies accounted for $702 million.

The picture at Woolworths is similar.  The company is diversified but the lion’s share of earnings comes from its Food and Liquor operations – $3.6 billion of the total $3.7 billion.  Woolworths earned $275 million from its hotel segment and its Masters Hardware segment lost $169 million.  The Masters Hardware is a joint venture between Woolworths and US based Lowes Corporation with the goal of competing with Wesfarmers’ Bunnings stores, the largest home improvement operation in Australia.  There are about 49 Masters Stores currently in operation and Woolworths recently scaled back its store expansion plans from 80 to 90 stores by 2016 to between 70 and 80 stores.

Wesfarmers is branching out into the financial services industry, expanding on its private label credit cards.  A joint venture with GE Capital will offer more financial offerings, including loans. The company is planning to add 70 grocery outlets over the next three years.  There is some speculation that Wesfarmers may be interested in acquiring wealth management company AMP Limited (AMP) or banking and insurance provider Suncorp Group Limited (SUN).   

Woolworths is adding 108 stores this year across its retail line, including groceries, liquor, and hardware and home improvement.  Of more interest to analysts is the company’s Mercury II plan, a $1 billion dollar investment in supply chain improvements to cut the cost of transportation.  In addition, Woolworths will use its jointly owned data analytics company to gather information about shopping habits to look for growth opportunities in both the brick and mortar stores and in online platforms.  It has been ten years since Woolworths launched Mercury I, which led to substantial productivity gains. Some analysts speculated the improvements from Mercury II could result in earnings growth approaching ten percent.

Wesfarmers price cutting strategy helped push the share price up 62% over five years, compared to only 20% appreciation for Woolworths.  Over the past two years, the price movement of the two companies is much closer.  Here is the chart.

Both companies have growth and expansion plans that could help shield them from competition from Aldi and the potential of more competition from other international food retailers like US based Costco and UK based Lidl.  The dividend history alone of both companies makes them worthy of consideration for long term income investors.  

Growth and valuation measures for WOW and WES are reasonable, if not spectacular.  Not so much for Metcash, however.  The following table looks at all three.

Company

(CODE)

 

Trailing P/E

Forward P/E

P/B

 

P/S

P/EG

5 Year Estimated P/EG

2 Year

Earnings Growth Forecast

2 Year

Dividend Growth Forecast

Wesfarmers

(WES)

 

18.8

18.05

1.93

0.83

1.71

2.59

12.6%

6.6%

Woolworth’s

(WOW)

 

17.5

15.8

4.17

0.7

4

2.8

5.6%

5.4%

Metcash

(MTS)

 

14.58

1.57

0.19

-9.2%

-7.9%

 

Wesfarmers appears to have an edge in earnings growth.  Although more analysts (7) have Buy and Overweight ratings on Woolworths, that data does not reflect the most current financial reporting.  

Looking at the numbers for all three of our table, it seems there is little to make a case for Metcash.  The share price has dropped dramatically since the onset of the price wars.  Here is a five year chart for MTS.

Simply put, Metcash’s independent food retailing customers can’t compete with the likes of Coles dropping the price of one litre of milk to $1.00.  In addition to the approximately 2,700 independent food and grocery retailers it supplies, Metcash has 18 distribution centers to supply liquor to about 15,000 retail outlets in Australia and New Zealand.  Metcash also holds a majority interest in an automotive parts wholesaler and supplies Mitre 10 and True Value Hardware outlets.

So let us try to make a case for Metcash suitable for longer term investors with nerves of steel.

The first thing Metcash has going for it can be seen in the number of stores it serves and in the independent ownership.  Independent owners are local business people capable of providing superior customer service as well as product selection tailored to a local market.  The total number of retail outlets in the Metcash network compares favorably with both Woolworths and Wesfarmers.

The second thing that could help Metcash is the Australian Competition and Consumer Commission (ACCC).  The Commission is investigating claims Woolworths and Coles use tactics to force suppliers to cut prices.

Finally, there is Project Diamond, the five year, $640 million dollar plan Metcash is putting in place to reverse the trend.  The plan was rolled out in March and some analysts called it ambitious, sound, but challenging to execute.  To fund the plan Metcash is cutting its dividend payout ratio from the current 80% to 60% along with improvements in working capital through operational efficiencies.

There are six points to this plan and Metcash is already piloting a Price Match program in 34 IGA locations in order to provide competitive shelf prices.  Product assortment will be more tailored to local needs, with a revamping of fresh food offerings and a re-structured line of private labels introduced.

Metcash is actively seeking additional independent retailers to add to its network.  The company will offer additional support to help independent retailers drive down costs of doing business, including a Retail Academy to train new retailers and to enhance the skills of existing retailers.

Five years can be an eternity in the modern business climate and analysts have already noted some independent retailers may resist the changes in the plan.  Whether it works or not, it’s generally a good sign when a company under fire aggressively takes action to compete.  

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