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Woolworths headwinds persist despite pandemic bounce

Emma Rapaport  |  24 Jun 2020Text size  Decrease  Increase  |  
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Woolworths customers may be emptying the shelves, but it's failing to translate into earnings growth at Australia's supermarket giant as COVID-19 interruptions bite.

Sales of consumer staples like toilet paper, handwash, pasta and eggs are booming but not enough to offset the effects of the pandemic, says Johannes Faul, an equity research director at Morningstar.

Strict social distancing measures and volatile consumer demand added operating costs of around $275 million in the fourth quarter of fiscal 2020.

Faul estimates Woolworths (ASX: WOW) also spent about $90 million to address health and security concerns in March 2020.

"We expect these costs to eliminate the benefits of incremental sales resulting from consumer stockpiling, more eating at home, and greater spending on hygiene," he says.

Purchase limits were first instigated three months ago following frustration from customers unable to access essential items. Supermarkets on Wednesday reinstated restrictions on grocery staples in Victoria following a spike in coronavirus cases in the state and scenes of panic buying.

The grocery retailer has also had to contend with a decline in foot traffic in metropolitan areas, impacting its express-style stores that offer café style service and hot food-to-go.

"Smaller-format Woolworths Metro stores in city centres temporarily turned from a lucrative growth channel into loss-making enterprise as foot traffic collapsed," Faul says.

Margin expansion unlikely

At Wednesday’s close of $36.12, Woolworths shares were trading more than 30 per cent above Morningstar's $27.50 fair value estimate.

The current share price suggests investors expect Woolworth’s margins to rise by 6.5 per cent over the longer term. Faul says this is unlikely given fierce competition from supermarket peer Coles, aggressive discounter Aldi and independents serviced by Metcash.

"Significant EBIT margin expansion has been illusive during the last four years," he says.

"We anticipate fiscal 2020 is set to be the fifth year without a material margin uplift. We maintain our long-term food EBIT margin forecast at around current levels of 4.5 per cent."

Hotels in lockdown

If you thought online sales helped Woolworths, think again — Faul says an uplift in e-commerce as people sought to avoid visiting stores actually diluted the supermarket’s margins.

"Although Woolworth's online sales are profitable, they are more costly to fulfil than traditional brick-and-mortar sales," he says.

"Online sales penetration of Australian food sales is currently around 6 per cent, a huge jump from the average rate of 4.4 per cent in the first half of fiscal 2020."

The company’s hotels business was also a significant drag on earnings in fiscal 2020, with pubs and clubs forced to shut their doors in the face of strict distancing measures. Faul forecasts the pub shutdown will result in EBIT declines of almost $100 million, or down 36 per cent in fiscal 2020 compared to the previous year.

Trading update

The company's latest trading update shows positive sales momentum continued into the fourth quarter, with growth accelerating in New Zealand, at BIG W and Endeavour Drinks. Australian Food sales are up 8.6 per cent and Endeavour Drinks sales are 21.4 per cent higher.

Woolworths expects full year earnings before interest and tax to be in the range of $3.2 billion to $3.25 billion. This compares to $3.29 billion last year.

The retail giant also announced its plans to replace three outdated distribution centres with two state-of-the-art facilities at Moorebank in Sydney's west. Total capital expenditures plus provisions for redundancies are expected to be around $900 million and spread over the next four years.

Faul welcomed this announcement saying the investment should deliver operating efficiencies. However, he anticipates competition means Woolworths will be forced to pass on these savings to consumers by lowering prices, reducing online delivery fees, or improving in-store service.

"Woolworths started automating its supply chain by investing some $500 million in the Melbourne South regional distribution centre, which is currently ramping up," he says. "Coles followed suit, announcing its plans to modernise its supply chain in October 2018."

Shares in Woolworths have pulled back about 17 per cent from their February highs, when they peaked at $43.60.

Stock price, 1-Yr | Woolworths (ASX: WOW) 

wow stock

Source: Morningstar Direct

is an editor for Morningstar.com.au

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