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Woolworths dodges the virus fallout

Emma Rapaport  |  27 Feb 2020Text size  Decrease  Increase  |  
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COVID-19 is spreading to Europe in beyond, infecting thousands and casting economic uncertainty across global markets.

In such a climate, investors seeking stocks with relatively predictable near-term earnings might be drawn to consumer staples like Woolworths (ASX: WOW) or Coles (ASX: COL).

Woolworths’ supply chain remains untouched by the virus for now, but Morningstar equity analyst Johannes Faul says the company is significantly overvalued, trading at a 48 per cent premium to his $27.50 fair value estimate.

"The effects on the Australian economy and domestic consumer spending are difficult to gauge, but we expect demand for most of Woolworths’ consumer goods to be robust in this environment," he says.

"Woolworths’ supply chain has not been disrupted by the virus, although management is staying vigilant.

"However, shares in Woolworths are priced to perfection and trade at a significant premium to our fair value estimate."

Faul says WOW's current share price implies adjusted EBIT margins of the core Australian food business are due to expand by some 300 basis points to around all-time highs of 8 per cent.

However, adjusted EBIT margins in Woolworths’ Australian food division increased by a disappointing 12 basis points to 4.8 per cent in the first half, despite solid like-for-like sales growth driving operating leverage and material stock loss improvements.

Related article: Investors ignore Wesfarmers, Coles risk at their peril

The first-half result was hurt by a net $51 million in one-off costs related to the planned Endeavour Drinks separation, and another $80 million for the underpayments review.

Profit from continuing operations slipped 1.7 per cent on a year ago.

Woolworths shrinks

WOW's other four segments – liquor, hotels, discount department chain Big W and New Zealand supermarket Countdown – were a bright spot in the results - delivering strong first-quarter sales. The segments account for 40 per cent of the group's profits.

Woolworths attributed Big W's improved performance to better product mix and continued cost management.

Woolworths main operations include supermarkets (under the Woolworths brand in Australia and Countdown in New Zealand), retail liquor (as BWS and Dan Murphy's), hotels and pubs under Australian Leisure and Hospitality Group (ALH Group) and discount department store Big W.

In July 2019, Woolworths announced its intention to pull the plug on pokies and pubs, merging the two segments into a combined entity called Endeavour Group. The integrated Endeavour Group comprises more than 1500 BWS and Dan Murphy’s retail drinks outlets and 327 ALH hotels and neighbourhood pubs, and commands about half of the market.

These businesses together make up about 30 per cent of consolidated earnings before interest and taxes. The combined entity was earmarked for divestment in calendar 2020.

Management still intends to separate Endeavour Group this year. No firm timeline was provided with the first half result. Whether this happens through a sale or some alternative is yet to be determined.

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Woolworths will pay a fully-franked interim dividend of 46 cents per share.

Faul says the separation could occur through an IPO, which could allow WOW to pay investors a special dividend. It could also occur via a trade sale, opening up the prospect of external acquisition. Or it could occur via an in-specie separation, whereby current WOW investors could receive shares in both companies. He says a trade sale is unlikely considering the sheer size of the Endeavour Group.

"The spinoff is a big activity that the market will focus on for the rest of the year," Faul says.

Woolworth's divestment came alongside mounting pressure from investors and activists for the group to distance itself from gambling activities. Woolworths is one of Australia's biggest pokies machine owner through its majority stake in ALH Group.

Underpayment blowout

The failure of Woolworths to adequately pay its staff for almost a decade also hurt first-half profit. The supermarket reported that staff underpayments have jumped to $315 million across a larger number of employees than initially thought, with the figure potentially rising further once a review is complete.

The company on Wednesday said it has repaid about $78 million to staff so far, including $69 million during FY20.

Faul expects Woolworths’ adjusted EBIT margins to decline slightly in the second half of fiscal 2020, mainly due to higher wage and salary expenses and the unwinding of some of the operating leverage benefits of the first-half as like-for-like sales slow in the second half.

Woolworths will pay a fully-franked interim dividend of 46 cents per share, up 1 cent on a year ago.

Morningstar has compiled a handy list of more than 150 companies under coverage that will release earnings results during February Reporting Season.

is an editor for Morningstar.com.au

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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