By Paul Rickard

I am always a little bit amazed by the number of people who want to buy shares in Woolworths. Maybe it is because it is a former market darling that fell on hard times as the supermarket wars heated up, or perhaps it is the idea of finding a turnaround story and backing it.

And judging by the market’s reaction to Woolworths' first-half result yesterday, it also thinks it has found a turnaround story. For the first time in 30 quarters (see table below), Woolworths' comparable store sales growth in food of 3.1% trounced rival Coles, which reported sales growth of just 1.0% for the second quarter. The market celebrated the better-than-expected victory, sending Woolworths shares up by $1.13 or 4.43% to close at $26.63.

Support for Woolworths has been building now for some weeks, as has a general re-rating of the consumer staples sector, which is dominated by the big three - Wesfarmers, Woolworths and Coca Cola Amatil. One of the worst performing sectors in calendar 2015 and 2016 (in 2016, the consumer staples sector returned 4.8% vs the broader market’s 11.8%), it is now almost starring in 2017, with a return of 6.8% this year compared to the market’s 2.9%.

Short positions are being closed, which is also lending support. According to the latest ASIC figures, open short positions in Woolworths are down to 67.2m shares, or 5.22% of Woolworth’s total share capital. While this is still high (Wesfarmers, for example, has 12.9m shares or 1.14% of its shares sold short), this is well down from circa 9.0% in mid-2016. Effectively, 49m shares sold short worth some $1.2bn have been covered.

But where to now for Woolworths. Is it in buy territory? Let’s start with yesterday’s half year report.

Sales momentum in first half

The market liked the sales momentum in supermarkets (see below), and the performance of the Endeavour Drinks group (Dan Murphy’s, BWS and other brands), which grew comparable store sales by 2.9% in the second quarter. Big W remains a problem child, with same-store sales declining by 6.7% compared to the corresponding quarter in 2016.

WES vs WOW comparable store sales - change on corresponding quarter 

*Adjusted for the timing of Easter

Financially, EBIT from continuing operations of $1,301m was down by $156m or 14.5% compared to the first half of 2016.

Somewhat surprisingly, Woolworths actually increased its gross margin in food, from 27.38% to 27.88%. It said that “material improvements in stock loss and better buying” offset its “investment in price” (price discounting). That said, its cost of doing business increased from 22.20% to 23.54%, meaning that the key EBIT to sales ratio fell from 5.18% to just 4.34%. It wasn’t that long ago that this metric was nearer 8%!

And this is the problem for Woolworths. It is hard to see any margin improvement. Coles, Aldi, IGA and Costco aren’t going away, and while the supermarket war isn’t (yet) exploding, it is not over either. Pricing pressures are likely to remain.

Sure, Woolworths can potentially fix Big W, but in an environment of 2% to 3% sales growth in supermarkets, unless the margin can lift, profit growth is going to be measured. 

Price metrics

Earnings per share from continuing operations in the first half were 61.3c. With the second half traditionally a little weaker for sales as the first half includes Christmas, this means that Woolworths will likely earn around 115c in FY17. This puts it on a PE of 23.2 times earnings. Projecting ahead to FY18 and forecast earnings of 125c per share, the multiple is 21.3 times.

Woolworths will pay a dividend of 34c per share for the first half, and target a payout ratio of 70% for the full year. Woolworths' shareholders can therefore expect a full-year dividend of around 80c, putting it on a yield of 3.0%. Interesting, but hardly exciting.

The brokers currently have a target price for Woolworths of $24.29. While there may be a couple of broker upgrades to valuation following the half-year result, it is currently trading at an 8.8% premium to the consensus valuation.

My view

I don’t think that the supermarket wars are over and find it very difficult to believe that Woolworths will be able to increase margin in its key supermarket business. A multiple of 23-21 times forward earnings is expensive compared to the market, and the sector (Wesfarmers is trading on a multiple of 16.3 times FY17 earnings and 16.2 times FY18 earnings). 

Sure, there are more shorts to cover and this might provide some support to the price. However, it looks very fully priced.

Pass.

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