What turnaround for Woolworths?
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The supermarket battle isn't getting any better for Woolworths (ASX: WOW), which has had to overcome Aldi's onslaught, clever marketing from Coles, and its own management hurdles.
According to one expert, the turnaround that many shareholders had hoped for isn't likely to happen.
With discount grocer Aldi expanding across Australia and Coles fighting back with its "Prices Are Down" campaign, Woolworths isn't having an easy time maintaining existing business.
Shareholders are unlikely to experience any big surge in the value of their investments, even with last year's change in management. New chief executive Brad Banducci has improved the company's operations, but that hasn't altered the competitive landscape.
"There has been a lot of talk about a turnaround in Woolworths' margins, but that is now not something that we see happening at all," says Johannes Faul, an equities analyst with Morningstar.
"We forecast Woolworths, Coles and IGA to all lose some market share to Aldi as it expands its store network. We think a turnaround is unlikely to happen because of Aldi's expansion and price competition will intensify and it is unlikely that Woolworths and Coles will expand their food margins.
"The price-cutting has resulted in food price deflation and tightening of operating margins, especially at Woolworths.
"On top of the near-term challenges, we identify two conceivable longer-term threats. The potential entry of discounter Lidl or online grocer AmazonFresh, or both, would introduce further pricing tension and increase pressure on margins even more."
Faul estimates Aldi will ultimately capture close to 10 per cent of the supermarket market share, up from around its current level of 6 per cent.
Woolworths will successfully defend its market share in food and liquor at around 34 per cent over the long term, compared to 35.1 per cent in 2015-16, by lowering its margins in its earnings before interest and taxes (EBIT) margins to 4.2 per cent.
"This is reasonable by international comparison, and Woolworths will remain viable and profitable, but the exorbitant margins that it enjoyed previously are very unlikely to reemerge. Indeed, Woolworths has already experienced a big drop in its margin to 4.8 per cent in fiscal 2016, down from 7.2 per cent in fiscal year 2015," Faul says.
Faul sees Woolworths fairly valued at around $22, giving it a 12 per cent premium on its closing price of $24.60 on 23 January. He had recently lowered that fair value from $28 given strong competition and the compression in its margins.
That compares to a fair value of $39 for Wesfarmers (ASX: WES), down from $42, giving it a 5 per cent premium on its closing price of $40.97 on 23 January.
So, for an investor who is considering buying either Woolworths or Wesfarmers shares, Woolworths is more overvalued. Moreover, it is less diversified than Wesfarmers so it could be a riskier play as its fortunes are more closely tied to the supermarket industry than Wesfarmers, says Faul.
"Most of Woolworths' income is from its supermarkets business and now that it's selling its petrol business, it will be even more focused on supermarkets, compared to Wesfarmers, where just over half of its operating earnings come from the supermarket industry," says Faul.
"So, if you want to be more exposed to supermarkets, then Woolworths will deliver that. But for someone who wants more diversification, you would probably want to hold Wesfarmers, in terms of value and all else being equal."
A last thought goes to IGA, Metcash's (ASX: MTS) network of independent retailers which is exposed to the same dynamics, but may experience relatively more pain.
"IGA stores are less able to compete on price than their integrated competition and we expect the network to continue losing a disproportionately high amount of share," says Faul, who put a fair value of on $1.80 on Metcash, below its current levels of around $2.12, and well off its all-time high of $5.40.
"We expect IGA to continue the trend of losing disproportionately more share to Aldi, due to the significant market share of IGA in Western Australia and South Australia, the two states which Aldi only just entered in 2016."
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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.
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