Woolworths - Risk Reward Becomes More Compelling

Last month, Evidente published an open letter to the Woolworths CEO, Grant O'Brien, suggesting that a lack of corporate focus had contributed to the company's poor recent performance.  The rollout of Masters stores since 2011 had been a significant drag on the group's performance, with the company having little choice but to push out the timing of break-even expectations from what in hindsight was an unrealistically aggressive timetable. 

The slowdown in sales growth of Australian Food & Liquor segment evident in the past year suggests that the expansion into home improvement has distracted management from its core supermarket business and taken up a disproportionate amount of management time and effort.  Woolworths has effectively bucked the recent trend towards corporate focus; the demerger wave of recent years amounts to corporate Australia waving the white flag on corporate diversification and acknowledging that focussed firms typically produce superior returns to their shareholders.

In an encouraging sign at the investor strategy day in early May, Mr O'Brien announced that Woolworths would re-allocate capital away from the under-performing Masters and Big W businesses towards supermarkets, including for store refurbishment.  Whether this represents a harbinger of an exit from these businesses remains to be seen.  In what amounted to a mea culpa, Mr O'Brien admitted that in seeking to preserve high margins, the supermarkets division had effectively sacrificed sales growth and customer loyalty, and flagged a shift in strategy designed to neutralise the community perception of Coles' price leadership.

Despite my ongoing concerns about the ability for the senior executives to effectively manage a number of disparate and under-performing businesses in the near term, particularly Big W and home improvement, the following set of charts suggest that at current levels, analysts and investors have become unduly pessimistic about the company's prospects. 

First, multiple contraction - rather than earnings contraction - has accounted for the lion's share of the stock's underperformance in the past year.  The 12mth forward earnings multiple has declined to 14x from 17.5x (see top panel of the chart below).  The bottom panel confirms that a continued deterioration of the company's incremental ROE coincided with the roll-out of the Masters stores which commenced in 2011, coinciding with the start of Mr O'Brien's tenure as CEO. 

Second, the stock is now trading at 14x 12mth forward earnings, which is a discount to the ASX200 (16x).  This represents the first time Woolworths has traded at a discount (see chart).

Third, Woolworths is trading at a discount to its global food & grocery peers based on profitability adjusted price to book ratios.  Valuation theory says that there ought to be a positive and linear relationship between a stock's expected ROE and its P/B ratio, and the positive regression line in the chart below confirms this.  After having traded typically at or above the regression line in recent years, Woolworths is now trading at a 10% discount based on this metric.

As analysts have downgraded its ROE outlook, the stock has undergone a material de-rating, particularly in the past year.  The chart below highlights the extent of the de-rating, and shows that if the stock's profitability adjusted P/B ratio was in line with its peers, it would be trading on a book multiple of 3.8x.

Fourth, when benchmarked against the stocks in the ASX100, Woolworths also offers compelling value.  Its profitability adjusted P/B ratio is more than 20% below the regression line (see chart).  A closer inspection of valuation theory suggests that this discount is unlikely to persist.  The perpetuity earnings discount model says that a stock's P/B ratio is equal to its future expected ROE multiplied by the reciprocal of k - g (expected stock return minus future expected growth in EPS).  The CAPM dictates that the only source of variation across stocks' expected returns is in a stock's beta; high beta stocks ought to trade at a discount, other things being equal.  So a stock's book multiple might remain below the regression line in equilibrium if has a higher beta than its peers and/or lower EPS growth expectations.

Woolworths' risk and growth characteristics suggest that it should not remain below the regression line for an extended period.  The lion's share of the company's revenues are generated in segments that are considered to be defensive, and most analysts use betas of less than 1 when constructing their discount cash flow valuations. So controlling for expected future growth, Woolworths ought to trade on a premium based on profitability adjusted P/B ratios. 

Moreover, long-term consensus expectations suggest that sell-side analysts have become too pessimistic about the stock's future growth prospects.  The long term growth forecast for the stock has fallen to only 2%, well below the median estimate (see chart).  Over the sweep of the past five decades, household spending on food & liquor has broadly tracked growth in the economy of around 5.5%.  Concerns around management quality and the long-term viability of home improvement are valid but in my view, do not justify the stock trading at a discount to its large cap peers.

Fifth, parallels between Tesco and Woolworths are exaggerated.  The collapse in Tesco's share price in 2014 owes much to the lack of transparency of its financial accounts following an accounting scandal.  Moreover, prior to the scandal, the stock was priced for perfection, trading at a large premium to its global peers on a profitability adjusted price to book ratio (see chart).  As discussed above, Woolworths is trading well below the regression line at present.

An excessive pessimism

I continue to have concerns around the long-term viability of the Masters stores in their current format, the fact that the composition senior management appears to be in a state of flux thanks to a number of recent departures, and remain sceptical of the purported synergies between running a supermarkets business and a being big box hardware retailer.  But in my view, the share price is already impounding excessive pessimism.  At these levels, investors should neutralise their underweight bet in the stock and use any renewed price weakness to start building an overweight position.