In the meantime, Woolworths recently released first-half sales figures, which revealed a clear slowing of food and liquor sales growth, which has been the key driver for earnings growth. In the December quarter, food and liquor comparable sales growth slowed to 6% compared to 7.6% for the September quarter. In addition, based on data from the Bureau of Statistics, Woolworths’ captured market share growth fell during the December quarter, for the first time in the past few years.
There is little doubt that Woolworths is a first-class company, with high quality management, and a dominant position in domestic supermarket retailing. However, clearly it is expensive and facing increasing earnings headwinds. The retail environment is deteriorating and the first signs are emerging that Woolworths is beginning to lose market share to the industry incumbents. Further, the easy market share gains from a distracted and weakened competitor are in the past. In addition, the other two recent drivers of earnings are slowing. First, the bulk of the supply chain initiatives have already been crystallised; and second, the "growth by acquisition" strategy has been restricted by the New Zealand competition regulator.
The other uncertainty for supermarket retailers is the ACCC's inquiry into pricing policies and supplier relationships. In addition, I believe there is a real risk of a further contraction in the gross margin as Woolworths continues to absorb rising food costs from the manufacturers. I remain a long-term bull on the soft commodity cycle and do not expect an easing of rising food prices anytime soon.
Still expensive
However, even after the recent correction, Woolworths is trading on a 2007-08 price/earnings (P/E) multiple of 22 times, or a 42% premium to the non-bank industrials of 15.5 times, and a 33% premium to the global retail peer group of 16.5 times. In the current economic environment, earnings uncertainty and risk-aversion is increasing. In this context it is very difficult recommending a cyclical company, at risk to slowing consumption spending, trading at a significant P/E premium to the non-bank industrial market.
My strategy focus remains on companies supported by a "value" multiple, or alternatively, generating "risk-adjusted" growth. However, at a 2007-08 P/E of 22 or 2008-09 P/E of 20, Woolworths is not displaying either of these characteristics. It is very difficult to recommend paying up for a cyclical growth company considering the risks for domestic economic growth are very much to the downside.
P/E derating?
The real risks for Woolworths are twofold. It appears that the key food and liquor division is experiencing slowing comparative sales and the first signs of market share loss with negative implications for earnings growth. In this environment investors have a very low tolerance for earnings disappointment.
The current investor mentality, particularly for stocks with a high P/E multiple is to "shoot first ask questions later".
Second, I think Woolworths is in a very similar situation to Commonwealth Bank at $60. Despite falling nearly 9% since my switch recommendation in late January, Woolworths is still trading at a big premium to the domestic market and the global peer group.
As a result, I believe Woolworths is a potential "short sell" opportunity for hedge funds seeking a low-risk funding vehicle. It is worth remembering that a similar scenario eliminated two P/E points from the CBA share price. A similar two P/E point de-rating for Woolworths could result in a further 10% fall from current levels.
I believe Woolworths is a classic "crowded" overweight trade where the previously defensive investment case has been compromised by a significant P/E premium over both domestic non-bank industrials and the global peer group.
WOW Price at posting:
0.0¢ Sentiment: Buy Disclosure: Held
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