Description

Woolworths (WOW AU) - SHORT

Price: 23

Market Cap: 29 b AUD

ADTV: $70 mm USD

Thesis

Woolworths (WOW AU) is a short because their supermarket business is in the middle innings of having their profitability and ROIC destroyed by price competition from Aldi’s acceleration of food market share growth in Australia. Continued price competition coupled with operational de-leveraging will take WOW’s EPS from $1.95 in 2015 to $1.24 in 2018 and the stock from $23 to $15 which is 35% downside.

The opportunity exists because last quarter WOW’s like-for-like (LFL) sales inflected to positive for the first time in 6 quarters which has led the market to extrapolate that LFL’s from here will be positive and that EBIT margins will stabilize this year and improve thereafter. We like this set up as we disagree that the business has stabilized (see key debates section below), and it de-risks the upside as the stock’s current valuation implies a stabilization or even improvement in margins, and it has led to a decline in short interest in the stock and improvement in sentiment.

Business Description

WOW is an Australian conglomerate operating primarily in the food retail sector. Australian supermarkets (Woolworths) is their primary business and 60% of EBIT. Australian liquor stores (Dan Murphy's, BWS) is 20% of EBIT, and the remaining 20% is comprised of a hospitality business, department stores, New Zealand supermarkets, and gas stations. WOW used to have a home improvement business called Masters that they are exiting.

WOW is one of the larger public companies in Australia, with a market cap of 30 b AUD, revenue of 58 b AUD, EBITDA of 3.5 b AUD, and a dividend (albeit one that has been cut recently). There a heavy index-tracking and retail ownership base in the stock. Short interest has declined from 10% earlier in 2016 to 6% today.

Industry Backdrop

The Australian supermarket industry had been a duopoly for many years between Woolworths and Coles. Together they achieved peak market share of 64% in 2013. Because of their scale and consolidated industry structure they enjoyed above average pricing power and EBIT margins of 8% which compares very favorably to other developed markets such as the US and UK where supermarket EBIT margins are ~3%.

As we have seen in other developed markets, when the supermarket industry has been able to earn MSD/HSD EBIT margins due to lack of competition, a pricing umbrella is created that opens up the opportunity for new retail formats such as discount stores to enter the market and offer an attractive value proposition to consumers. We saw this in the US with the rise of Wal-Mart, in the UK with the rise Aldi/Lidl, and Australia is turning out to be no different with the entrance of Aldi in the early 2000's but acceleration in new stores and market share post-2008 GFC that coincided with a lack of price discipline and expansion of EBIT margins for Woolworths/Coles from 5% to 8%.

Aldi's strategy thesis is that a large segment of the market will trade in-store shopping experience and branded products in exchange for savings ~20% on the basket shop. By operating a no-frills store with mostly private label products they consistently offer a 15-25% price advantage on a comparable basket to Woolworths/Coles and still earn a ~4% EBIT margin for themselves.

Aldi has grown from 240 stores and 3% national market share to ~440 stores and 7% national market share today. Until last year all of their growth has been on the East Coast of Australia, and in those markets their share is 10-12%. Until last year Aldi was opening up 30 stores and capturing 50 bps of national market share annually. In 2016 Aldi doubled their store opening pace to ~ 60 stores of which half are on the East Coast and half are to enter new markets (South and West Australia), doubling their annual market share gains to ~100-120 bps. Aldi's public plans are to continue their present new store growth while also spending an incremental $1 b of to improve their fresh (fruits/vegetables) distribution chain and store presentation (fresh is a key area for consumers and one where Aldi hasn't competed as well in), with the goal of accelerating their annual market share gains.

This November 2016 interview of the Aldi Australia CEO by AFR is a good summary of their plans - http://www.afr.com/business/retail/aldi-australia-gets-fresh-as-sales-exceed-7-billion-20161101-gsfels

Where Aldi enters and gains ~ HSD market share (enough to materially hurt the incumbents traffic and LFL's), profit pool destruction follows. The high-priced incumbents face a tough choice 1) keep prices and profits high and cede market share which over years eventually creates negative traffic and basket growth and operational de-leveraging or  2) rip the band-aid, reset prices and EBIT margins lower, but stabilize market share and the business for the long-term. Neither choice is attractive for a public management team, but more often than not they choose option #1, everything is ok for a few years, but eventually LFL's inflect negative, the market panics, and the board replaces the management team with a new team that then rips the band-aid. This is what happened at Woolworths in 2015-2016 as Woolworth’s bleeding of market share and customer traffic triggered operational de-leveraging, a turnover in management team, and an admission that pricing was too high in the stores leading to a $1 b investment in price that cut EBIT margins from 8% to 4.5%. 

The key debate for the stock is what happens next in the supermarket business with any reaction to WOW’s price investment by the competition, and WOW’s LFL’s & margins. Have the recent price investments stabilized market share? Can LFLs inflect to 2+% to allow for stable/growing EBIT margins?

Current Narrative / Key Debates

The bull thesis on WOW is that a new management team is going back to basics with WOW, divesting non-core businesses and focusing on the core supermarket business. Bulls believe that 2016’s price investments have worked, LFL’s and market share have bottomed, and EBIT margins can stabilize and grow from 4.4%.

Our variant view is that competitive intensity is increasing, WOW’s price investment is likely to elicit a response from both Coles and Aldi, WOW LFL’s will remain under pressure and not be able to leverage their cost base, and we are only in the middle innings of the Australian supermarket profit pool resetting to a lower base. While less relevant to the narrative, we also think divestments of non-core businesses do not unlock a sum of the parts value story, and to-date have proved challenging even to exit let alone extract any value from (Masters, Big W, and Gas Stations).

Industry competitive intensity is increasing:

·         Aldi is accelerating store openings, investing $1 b into their existing store base to expand their fresh offering, and is publicly declaring that they will lower pricing to whatever is necessary to maintain their price gap to Coles and Woolworths and continue taking share. Aldi will continue to take 100-150 bps of market share per year which is a massive headwind in a sector that is only growing 2-3% to begin with.

·         WOW’s price investment succeeding in taking share from Coles in the 9/30/16 quarter as Cole’s LFL’s decelerated from 3.3% to 1.8%, below their cost base inflation. While Coles management played down a price war on their earnings call, they did say they would continue to invest in price. Last year Coles invested 40 bps of gross margin in price, if we saw a similar investment in 2017 it would be meaningful and enough to force WOW to respond if they want to maintain positive traffic. We will find out in the next 3-6 months how aggressive Coles will act which is a key signpost to monitor.

·         In recent weeks industry checks have picked up that Amazon Fresh is expected to enter Australia in 2017, which could potentially introduce a completely new disruptive force for Australian food retail.

WOW sales growth improved last quarter, but it’s not enough to improve margins and not indicative of a turnaround:  

·         The market got overly excited about the inflection in LFL’s from negative 110 bps in the 6/30/16 quarter to positive 70 bps in the 9/30/16 quarter. There was little discussion about the fact that the 9/30 quarter has the easiest comp of the entire year (9/30/15 LFL was negative 160 bps, the worst of the fiscal year). The 2-year stack was negative 90 bps, still abysmal. A 90 bps 2-yr stack for the 12/31 quarter would imply a quarterly LFL of positive 30 bps, which given how focused the market has been on small changes in LFL trends would be interpreted negatively since it’s a deceleration vs. the 9/30 quarter.

·         After posting the positive 70 bps LFL management talked down extrapolating the result into a positive inflection in the business, saying it was just one quarter and they view the turnaround of Woolworths as a multi-year project.

·         Total food industry growth is only 2-3% driven by population growth and barely positive food CPI. Aldi is taking 100-150 bps of this. This is a tough macro backdrop to try and drive LFL’s to at least 2% to leverage fixed costs.

WOW EBIT margins continue to decline:  

·         There is nothing structural about the Australian supermarket industry that suggests the incumbents should be able to earn above-average margins. In fact, in the early 2000's when the market was more fragmented and there were hard discount players present Woolworths earned a 3-4% EBIT margin. Interestingly, Coles and Woolworths acquired these hard discount concepts and over time converted them to traditional supermarket stores or closed them down, removing the discount competition in the marketplace while consolidating market share. This was an important factor fueling their EBIT margin expansion over time. But it also allowed for the entrance of new discount competitors like Aldi.

·         Food EBIT margins declined an astounding 350 bps in the year ending 6/30/16 and management has guided to the first half ending 12/31/16 EBIT margins to decline ~80 bps as they finish lapping the price investments made in the last twelve months. There is zero evidence that margins should stabilize from there (4.4%) but that is what the market is extrapolating after the positive LFL’s in the quarter ending 9/30/16.

·         As noted above, fixed cost inflation is 2% so LFL’s of 2% are required to keep margins stable, holding all else constant. We won’t see 2% LFL’s this year even if we are wrong on industry competitive intensity increasing. If we get a response from Coles and Aldi then there is significant downside to EBIT margin expectations.

Divestments of non-core businesses may help improve focus but do not unlock value:

·         There is no sum of the parts story here. Even using generous valuations for the non-core assets the implied valuation for the supermarkets is excessive (see valuation section below).

·         WOW has a levered balance sheet, with a 3.2x fixed charge coverage ratio at the high end of what the ratings agencies have stated is within an IG-rating. Any proceeds from asset divestitures that are EBITDA-generating will need to be used to pay down debt vs. return to shareholders. WOW has already cut the dividend twice this year and is currently paying half the remaining dividend in stock to manage their leverage.

·         Big W (department stores) was the one asset that didn’t produce EBITDA that was rumored to have a valuation in excess of what an EBITDA multiple would imply, but last week the President of that business unit resigned after a terrible quarter and management color is that the turnaround of that business will take years, not quarters. This suggests a value-unlocking sale is not happening near-term.  

Valuation

Current valuation – On consensus estimates, at $23, WOW is trading at 10x EBITDA and 19x 2017 consensus EPS. Expectations are for LSD growth in 2018 vs. 2017. These multiples compare to a 3-yr historical average of 17x NTM EPS and a 5-yr of 16x NTM EPS, with a low of 13.5x and a high of 21x. FCF is 30-40% less than EPS due to higher capex than depreciation (new stores growth, now renovations in the stores). The dividend yield is 3% and references a 70% payout of EPS. Backing out the non-supermarket businesses, the implied valuation for the supermarkets is 13x 2017 EBIT or 18.5x un-levered after-tax earnings. These estimates assume EBIT margins stabilize at the 4.3% the supermarkets exited the 6/30/16 half-year at, which is in line with how management has guided for FY17 ending 6/30/17.

Our upside price target assumes the company accelerates to 2% LFL’s in 2017 and 2018, achieves 25 bps of margin expansion, which delivers $1.31 of 2018 EPS and trades at a 20x multiple = $26 or 13% upside.

Our downside price target assumes stable LFL’s but continued EBIT margin compression to 4.0% by 2018, delivering $1.13 of 2018 EPS and trades at a 13x multiple = $15 or 35% downside.

Every 25 bps of EBIT margin in supermarkets is worth 5 cents of EPS to WOW (4% of EPS). Ultimately, if EBIT margins are headed to 3.0% EPS would decline to 93 cents or 18% lower than our 4.0% margin downside case and the stock could be cut in half.

Risks to the Short Thesis

·         Continued improvement in quarterly LFL’s gives management the benefit of the doubt in the short-term even if margins continue to be under pressure.

·         Coles doesn’t respond to WOW’s price investments and allows market share losses without a corresponding margin hit through promotional activity.

Catalyst

·         Coles/Aldi price cuts confirms competitive intensity is increasing.

·         Management guides to lower margins at the half-year results in February 2017, taking numbers down again.

·         More details emerge about Amazon Fresh’s entrance and its potential impact becomes a source of uncertainty for the market.