The Supermarket Price War How it will affect your portfolio

report published FEBRUAry 2011

If you’ve turned on the telly or been to the shops lately, you’ve probably heard about the price war going on between ’s supermarket giants. But with the price of everyday groceries tumbling, should investors in our three listed supermarket stocks Woolworths, Wesfarmers and , be worried? In the first piece of this three part report, we’ll explain what impact the supermarket price war might have on this trio, both collectively and individually. We’ll also reveal which stock we wouldn’t buy and, in the research that follows, we’ll make the case for the two that we would.

Blue chip industrial | James Greenhalgh

Supermarkets’ milch cow

‘Coles steps up grocery war by slashing milk price’, shrieked the headline. Since then, the story has unfolded thus: Supermarkets are engaged in a vicious price war and shoppers Key points will triumph. It’s in the newspapers so it must be true. Media coverage of a supermarket ‘price war’ is Price wars are good for shoppers but bad for businesses (and their shareholders). overblown With buy recommendations on two of the three supermarket companies, Woolworths Woolworths’ superior margins would make it best- and Metcash, will a price war damage supermarket profitability? And, with Coles resurgent placed in any case under Wesfarmers’ ownership, are we backing the wrong horse? Let’s investigate. Wesfarmers is much more expensive than either The major supermarkets have been engaged in a ‘price war’ of sorts for years. There Woolworths or Metcash was a ‘grocery price war’ back in 2004 according to Today Tonight (apparently sparked by ). In 2006, Woolworths announced its ‘Rollback’ price reduction strategy. In 2009, the wesfarmers | wes supermarkets engaged in a ‘petrol price war’. Then, in early 2010, Woolworths announced Price at review $34.34 it was cutting the shelf prices of 3,500 items. Throughout all of that, Woolworths’ margins steadily increased (see Chart 1 over the page). Review date 17 Feb 2011 Price wars are more media inventions than they are genuine battles. In a cosy duopoly Market Cap. $39.7bn it makes little sense for rational players to damage profits with a real price war. And Coles’ 12 mth price range $27.09—$34.83 Ian McLeod and Woolworths’ Michael Luscombe are nothing if not rational. Fundamental risk 2

So what’s really going on? Milk is a consumer staple, inconveniently located at the Share price risk 2.5 rear of the shop. A cut in the price of milk attracts people away from the more expensive Our view HOLD independent operators and drives foot traffic. This analyst, for example, recently headed to Woolworths for one dollar a litre milk—ignoring his more convenient independent supermarket (supplied by Metcash)—and walked out with $35 of groceries. That’s what this ‘war’ is all about. The Intelligent Investor

For the sake of argument, though, let’s assume the war is genuine. What company—Coles or Woolworths—is best placed to withstand it? Chart 1 shows Woolworths has much more Chart 1: EBIT margins (%)* room to manoeuvre on pricing. Whilst Coles’ margins have improved since Wesfarmers acquired the business in 2008 (and are likely to improve further), they lag its rival’s world- 6.5 6.0 class numbers by some way. If Woolworths is last year’s model, this margin discrepancy 5.2 5.5 shows that Coles still requires some panel-beating and a paint job. 4.2 4.5 Nevertheless, Coles is finally gaining traction with shoppers, starting with its impressive 3.8 3.9 3.7 3.4 3.3 new store format (see Wesfarmers gets Coles format right on 23 Jul 09 (Hold—$24.27)). 2.8 Since then, Coles has linked itself with successful television franchise Masterchef and launched promotions such as ‘Feed your family for under $10’ and ‘Prices are down’. Recently, it has announced the removal of hormones from its beef. Other sourcing initiatives are in the pipeline. One-dollar milk is really just one of many ways Coles is trying to win 2005 2006 2007 2008 2009 2010 the hearts and minds of shoppers. Woolworths Coles It’s also winning their wallets, as recent sales figures show. While Woolworths had long * Australian food and liquor generated better sales growth than Coles, a baton change occurred in the first quarter of 2010. Coles can now boast six consecutive quarters of same-store sales growth exceeding Woolworths’ (see Chart 2). Recently, that gap has widened. Chart 2: Same-store sales Sales growth is important because retailers have significant operating leverage (see growth (%)* Shoptalk). Greater sales per store leads to greater profitability, which is why Coles’ margins are likely to rise further. 7.9 Conversely, Woolworths will struggle to increase margins if sluggish sales growth 7.3 6.6 continues. This at least partly explains its recent profit downgrade (although, as companies 6.2 5.86.1 5.9 tend to do, Woolworths blamed everything from lower inflation to bad weather rather than admit to a reinvigorated competitor). We’ve long been expecting slower growth, so its 4.2 3.8 3.8 arrival should cause little heartache. Selecting stocks isn’t just about choosing which company is growing earnings the fastest. 2.5 If it was, you’d buy Wesfarmers, which will increase 2011 earnings strongly thanks to Coles 1.8 2.0 1.6 and its Resources division. Rather, it’s vital to pay the right price for those earnings. While the price-to-earnings ratio is a simplistic valuation tool, the PERs of the three stocks clearly illustrate market expectations for them. 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 Metcash has the lowest forecast PER, reflecting slower-than-historical expected growth Woolworths Coles in 2011. It also reflects competitive threats to its liquor distribution arm and Campbell’s * Australian food and liquor Wholesale. While these threats are real, they’re reflected in the price you’re paying—a very reasonable PER of 12.6. Despite the fact Metcash has been dealing with competition from Coles, Woolworths, Aldi and others for years, it has consistently increased profitability. Shoptalk Woolworths can also stand on its record. Chart 1 shows this to be the superior supermarket business. But the forecast PER of 15.2 is lower than it has been for many Operating leverage: Operating leverage is an indicator of how a company’s profitability years because its main rival is attracting admiring glances from Mr Market. fluctuates with changes in revenue. For a No wonder that Wesfarmers, at 18.6, trades on the highest PER of the three. We’d argue company with high operating leverage, each this is a worryingly high figure. Wesfarmers owns a number of cyclical and lower quality additional dollar of sales becomes increasingly businesses that would trade on lower multiples were they separately listed. profitable. So as revenue grows, profit grows faster. But if revenue shrinks, profit also shrinks None of this implies Woolworths or Metcash will regain their former glory quickly. faster. The greater the percentage of a company’s If anything, recent profit downgrades might not be the last. But underestimating these cost base that is fixed in nature (as opposed companies’ management teams is a mistake. At the moment, you’re not paying much for to variable costs that move up and down with their potential to recover. sales), the higher the operating leverage. That’s not the case with Wesfarmers. Profit growth of 50% for Coles is already expected between 2010 and 2012; Target’s margins are at all-time highs and the Resources division is booming. These factors are supporting the stock’s premium rating, but none are wes Recommendation guide necessarily irreversible. Buy Up to $20 Mr Market’s excitement has driven Wesfarmers’ share price up 6% since 20 Aug 10

Long Term Buy Up to $25 (Hold—$31.95). For now, Wesfarmers remains the least attractive of these three stocks. We’ve bumped up our recommendation guide prices slightly to reflect the company’s Hold Up to $35 improving fortunes but a downgrade to Take Part Profits is approaching. For now, HOLD. Take Part Profits Above $35

2 Special Report | The Supermarket price war

Blue chip industrial | Nathan Bell

WOW! A great price for Woolies

Woolworths is a fine company that, finally, is trading at an attractive price. And there are good reasons for that. woolworths | wow Price at review $26.57

In Good to Great, author Jim Collins says, ‘Level 5 leaders channel their ego needs Review date 17 Feb 2011 away from themselves and into the larger goal of building a great company. It’s not that market cap. $32.7bn Level 5 leaders have no ego or self-interest indeed they are incredibly ambitious. But their 12 mth price range $25.38—$30.18 ambition is first and foremost for the institution, not themselves.’ In stark contrast to former Coles managing director John Fletcher, who boasted that he Fundamental Risk 1.5 hadn’t set foot in a supermarket for 25 years prior to his appointment, Woolworths chief Share price risk 2 executive Michael Luscombe spent almost three decades climbing the executive ranks; Our View Long Term Buy from Mt Buller trainee to leader of Australia’s largest retail company. That Luscombe still views himself as a shopkeeper reflects his focus on results, and not his ego. On 19 Jul 06 (Hold—$19.99), we canvassed Woolworths’ future under Luscombe; Key points back then, the forecast price-to-earnings ratio (PER) of 24 reflected high expectations, Woolworths owns an impressive supermarkets and they were spot on. business supported by a world-class distribution system, in addition to strong brands such as Big W When Luscombe handed in his annual report card on 26 August last year, earnings and Dick Smith per share (EPS) had doubled since then; a remarkable feat for what was then a $22bn Large investments are needed to move the needle company managed by a debutante chief. on profits However, Luscombe disappointed analysts recently by downgrading earnings guidance The stock is better suited to conservative portfolios at on reduced consumer spending and lower food price inflation. Luscombe still expects current prices, as we’re not expecting a total annual annual profit growth of between 5% to 8%, but Woolworths hasn’t delivered single-digit return above 10% profit growth since before the turn of the millennium. Woolworths’ forecast PER of 15 is as low as it’s been for many years. But with an equally attractive forecast dividend yield of 4.6%, we’re not about to pass up the opportunity to buy one of Australia’s finest businesses at a decent price. But companies of Woolworths’ chart 1: Woolworths: calibre don’t sell this cheaply without a few flies in the ointment. Performance vs price

Blue ribbon quality 1.80 30 The list of reasons to own Woolworths is long. Its Australian supermarkets are among 1.50 25 the finest businesses in the land, generating obscene returns on capital of around 77%; 1.20 20 what Woolworths loses in pricing power selling everyday products, it recovers by selling 0.90 15 huge volumes of them. Its world-class distribution system means it can afford to roll back prices to attract 0.60 10 more customers. As volumes increase, Woolworths extracts lower prices from suppliers 0.30 5 and passes the savings on to shoppers. This virtuous cycle, and an irreplaceable portfolio 0 0 of conveniently located supermarkets, is a daunting barrier to competition. 2002 2004 2006 2008 2010 Woolworths also owns strong brands in discount variety (Big W), consumer electronics EPS (LHS, $) DPS (LHS, cents) PER (RHS, x) (Dick Smith) and liquor (BWS and Dan Murphy’s), and its Everyday Rewards program and Source: Woolworths annual reports fuel discounts help funnel loyal customers back to its supermarkets. Woolworths produced $2.7bn of operating cashflow in 2010, and is in rude financial health. The company also reinvested $1.4bn refurbishing stores and expanding its network, leaving $1.1bn for dividends; Luscombe knows that today’s refurbishment is tomorrow’s dividend increase. Put plainly, this company is a gargantuan cash machine. So why isn’t the share price reflecting this?

3 The Intelligent Investor

Price of success Woolworths has become a victim of its own success; size is an impediment to growth and it takes large investments to move the needle on profits. For example, for Luscombe Luscombe’s A+ report card to repeat his magic by doubling net profit again in the four years between 2010 and 2014, Year to 30 Jun 06 07 08 09 10 sales would also have to double to over $100bn (assuming a constant net profit margin,

Revenue ($bn) 37.8 42.5 47.0 49.6 51.7 which was 3.9% in 2010). In comparison, revenue has ‘only’ increased a relatively paltry 37% ($14bn) between 2006 and 2010, with improving margins predominantly responsible NPAT ($m) 1,015 1,294 1,627 1,860 2,038 for doubling profits (this won’t be repeated without massive, miraculous acquisitions). EPS (c) 90.9 108.8 134.9 150.7 164.0 Luscombe is keen to find new growth avenues. Woolworths operates a joint venture PER (x) 28.6 23.9 19.3 17.3 16.0 in India, but this is small beer, and Luscombe’s operatives have also been sizing up targets DPS (c) 59 74 92 104 115 in the US. Franking (%) 100 100 100 100 100 We’re wary of a major offensive on foreign soil, given there’s a track record of Australian

Yield (%) 2.3 2.8 3.5 4.0 4.6 companies blowing up billions of dollars and returning home with their tails between their legs. However, the current economic concerns may produce a bargain; Woolworths often teams up with local players, too, which reduces the chances of getting hoodwinked. We’re also sceptical of the local joint venture with US hardware retailer Lowe’s, which will compete head on with . Even if Luscombe mollifies the doubters, overall returns on capital will likely fall due to dilution of the wonderful supermarket business. chart 2: wow 5-year share price Lastly, store rollouts are also waning due to Australia’s abundance of supermarkets and reduced property development following the credit crisis. Woolworths faces stiff competition $35 from Coles, , Aldi and private operators, including IGA, for suitable locations. $30 $25 Road Map $20 Woolworths’ enormous success has created high expectations, and it’s currently being $15 punished because the stockmarket generally prefers companies that are growing quickly. $10 However, we’d be content if Woolworths grew earnings ‘relatively safely’ by 5% to 6% a year, which equates to a total annual return of around 10% (including dividends). $5 This would likely be achieved if Woolworths sticks to its strengths, which are cutting $0 Feb 07 Feb 08 Feb 09 Feb 10 Feb 11 costs, processing higher volumes through its distribution network and incrementally rolling out new stores. So we’ll be watching for any signs that might cause us to reconsider our investment. A major overseas acquisition would certainly grab our attention, particularly if it were funded with debt. We’ll also be following the roll out of the hardware joint venture closely. Woolworths’ enormous However, it will be difficult to spot a poor outcome before the market and it’s a five-year success has created high investment, so things could change substantially in the interim. expectations, and it’s currently Management can’t afford to drop the ball with its cash cow businesses, either. If being punished because the Luscombe’s forthright commentary were replaced by corporate guff that glossed over poor results, then it would be a red flag for investors. stockmarket generally prefers companies that are Greatness within growing quickly. According to Jim Collins, ‘10 out of 11 good-to-great CEOs [that his research identified] came from inside the company. Level 5 leaders are fanatically driven, infected with an incurable need to produce sustained results. They are resolved to whatever it takes to make the company great, no matter how big or hard the decisions, and display a workmanlike diligence, more plow horse than show horse.’ Luscombe is a company man who appreciates the legacy he’s inherited; Woolworths gets results without the fanfare that has plagued rival Coles, for example. We’re also wow Recommendation guide comforted that Luscombe takes a long-term view and has been an excellent steward of Buy Up to $24 shareholders’ capital so far.

Long Term Buy Up to $29 Woolworths is perhaps more suited to conservative portfolios at the current share price, as we’re not banking on a total annual return over 10%. Hold Up to $40 In the search for cheap stocks, it’s easy to miss the bargain right in front of you. Take Part Profits Above $40 Woolworths faces challenges, but they’re not insurmountable. We’ve laid out our road map and we’re not about to look a gift horse in the mouth; Woolworths is a wonderful business trading at a fair price. LONG TERM BUY.

4 Special Report | The Supermarket price war

Blue chip industrial | Nathan Bell

Metcash: Top quality, budget price

Metcash is trading within spitting distance of its lowest ever price-to-earnings ratio; it’s time to step up. key points Metcash hasn’t offered such good value in years Dollar-conscious grocery shoppers load up their trolleys when items go on sale. It makes The company enjoys a profitable niche between its perfect sense; take advantage of low prices and cut your shopping bill. two larger rivals Stocks are no different. When they’re cheap that’s the time to load up. And right now A large fully franked dividend will make up much of independent supermarket supplier Metcash is in the bargain bin. the overall return Asked to name Australia’s third largest grocery player, few consumers would answer ‘Metcash’. So if you’ve never heard of this business, don’t be surprised. The company metcash | mts commands a 19% share of our national grocery market, as you can see in Chart 1, but Price at review $4.13 it doesn’t own a single store. Instead, it licenses the IGA brand to private operators and typically supplies them with more than 60% of their stock, which includes the Black & Gold Review date 17 Feb 2011 home brand range. Market Cap. $3.1bn The IGA network boasts over 1,300 supermarkets, which arms Metcash with bulk 12 mth price range $3.84­—$4.57 buying power over suppliers. In turn, the savings allow operators to drop shelf prices and Fundamental risk 2.5 compete in the same ballpark as Coles and Woolworths—Metcash chief executive Andrew Share price risk 3 Reitzer has said that Metcash’s bottom line would double if it competed on a level playing field with Coles and Woolies. Our view long term buy

Size doesn’t matter Chart 1: Metcash grocery Unlike its bigger rivals, which typically boast large stores, IGA stores come in a variety market share (%) of shapes and sizes, including SUPA IGA and IGA X-press. This means they can squeeze 20 into smaller, convenient locations where shoppers are prepared to concede higher prices to get in and out quickly (IGA’s prices tend to fall when competing Woolworths and enter the neighbourhood). Though the average shopping list is also much 15 shorter, this is Metcash’s point of difference; competing head on with its larger rivals would be financial suicide. 10 Metcash adds value by acting as a central buying agent; armed with the collective buying power of thousands of independent grocers and liquor retailers, Metcash negotiates lower 5 prices with suppliers than store owners could privately. That Metcash is merely a supplier and doesn’t own or lease any bricks and 0 mortar is both a curse and a blessing. It means Metcash is less profitable than ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 Woolworths, for example, as you can see in Chart 2, as it splits the margin between the Source: Metcash annual presentations cost and shelf price with store owners (Woolworths and Coles keep every dollar); this allows operators to earn a healthy return and reinvest in their stores. But there’s always a risk that renegade shopkeepers join an alternative buying group or bravely choose to go Metcash adds value by it alone. acting as a central buying On the flipside, however, Metcash has grown quickly because it hasn’t had to develop its own store network, which takes time and large licks of capital; Metcash can add new agent; armed with the stores at the cost of a phone call. That IGA carries a relatively narrow product range also collective buying power of means Metcash deals with fewer suppliers and products, which creates storage and thousands of independent distribution efficiencies. grocers and liquor retailers, Better still, management is shareholder friendly. Though Reitzer typically cashes in his company options, he runs Metcash like he owns every share. For example, Metcash negotiates lower practically all profits are distributed as fully franked dividends and, in a far-sighted prices with suppliers than move reminiscent of Woolworths, last February Reitzer served notice that he will retire storeowners could privately. in three years to ensure there’s a smooth transition at the top (though we’d prefer it if he stayed).

5 The Intelligent Investor

Price check So why is Metcash trading at a knock down price? Firstly, analysts prefer growth stories, like Coles, as they’re far easier to sell to brokerage clients. Chart 2: Metcash vs Woolworths (%) Metcash has increased earnings per share (EPS) 25% annually since 2001, when it commandeered the sinking retail ship Davids and orchestrated a phenomenal turnaround. 40 But it’s now approaching middle age, as the supermarket industry is mature and suitable 35 locations are diminishing. 30 Early on, Metcash’s share of the grocery market increased in leaps and bounds, but it 25 has meandered since carving up Foodland with Woolworths in 2005, as you can see in 20 Chart 1 (on the previous page). From here, Metcash’s growth will reflect how successful it 15 is in achieving its aim of supplying 80% of its customers’ stock, by expanding its IGA Select 10 range and delivering more fresh produce and meat from its new distribution centres. 5 However, like rinsing grey hair with Restoria Express, Reitzer is aiming to stall the ageing 0 process with acquisitions. ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 Shopping list MTS - ROA WOW - ROA MTS - ROE WOW - ROE The recently attempted acquisition of the New South Wales Franklins grocery chain was Source: Metcash and Woolworths annual reports an opportunity for Metcash to breathe new life into some underperforming supermarkets, in turn creating value for shareholders. Disappointingly, the deal was knocked back by the consumer watchdog, the ACCC. There’s still a small glimmer of hope but, as the grocery Chart 3: mts 5-year share price market is mature, future opportunities for these types of deals will be rare. Metcash is also sounding out opportunities in overseas markets. Though, having abandoned $5.50 a joint venture in the Philippines in 2003, we’d prefer Metcash remained twice shy. We’d take stock and reassess if the company announced a material overseas acquisition. $4.75 We’re also sceptical of the $55m paid for a 50.1% stake in hardware co-operative (Metcash also has an option to purchase the remaining 49.9% in 2012 or 2013). $4.00 Mitre 10 has buckled under the weight of Bunnings Warehouse’s lowest price guarantee, and it might be squashed flat by Woolworths’ joint venture with Lowe’s. We’re not overly $3.25 concerned, though, as the investment is relatively minor and failure wouldn’t likely have a

$2.50 lasting impact on Metcash’s healthy balance sheet. Feb 07 Feb 08 Feb 09 Feb 10 Feb 11 Quiet achiever While limited growth options mean Metcash won’t repeat the returns of the past mts recommendation guide decade, we’re not prepared to write off a company that ranked among Australia’s 10 best Buy Up to $3.60 businesses just yet. Long Term Buy Up to $4.50 The grocery business is still minting cash and, while management have backed away from

Hold Up to $6.00 previous guidance of 6—8% EPS growth, it still trades on an attractive forecast PER of 12.6. But today’s investor doesn’t need much growth to do well given the fat fully franked Take Part profits Above $6.00 dividend yield of 6.2%. And, given these dividends will likely make up the bulk of our overall return, this stock will likely appeal to income investors. Though we’re comfortable with leisurely earnings growth, provided Metcash defends Portfolio point its competitive moat and the dividend cheques keep turning up, our greatest fear is that Woolworths and Metcash are high quality Reitzer—or his replacement—does something drastic and risky to stoke the growth fires, companies but, as their Long Term Buy but we’ll cross that bridge if and when we come to it. recommendations indicate, they aren’t bargains. We recommend a weighting of no If you’re after a high quality business boasting a healthy yield, Metcash is a great stock more than 5% to each stock (less if you own to add to your shopping basket. LONG TERM BUY. both), which allows room to buy more should Note: The Income portfolio owns shares in Metcash and Woolworths. their respective share prices fall. Disclosure: Staff, including James Greenhalgh, own shares in Metcash.

Important information The Intelligent Investor WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice PO Box 1158 | Bondi Junction NSW 1355 from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people. T 1800 620 414 | F (02) 9387 8674 DISCLAIMER This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of [email protected] its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation. www.intelligentinvestor.com.au COPYRIGHT© The Intelligent Investor Publishing Pty Ltd 2010. The Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288). PO Box 1158 Bondi Junction NSW 1355. Ph: (02) 8305 6000 Fax: (02) 9387 8674. DISCLOSURE As at 17 February 2011, in-house staff of The Intelligent Investor held the following listed securities or managed investment schemes: AAU, AAZPB, ABP, ACK, AEJ, AGIG, AHC, ALL, ALZ, APH, ARP, AVG, AVO, AWC, AWE, AYT, BBG, BER, CAH, CBA, CCK, CFE, CIF, CLS, CMIPC, CNB, CND, COH, COS, CRC, CSL, CTE, CUE, CVW, DVN, EBT, EFG, ELDPA, FGL, FLT, FXL, GRB, HVN, IAG, IDT, IFL, IFM, IMF, IVC, KRS, LMC, LWB, MAP, MAU, MFF, MLB, MNL, MQG, MTS, NABHA, NBL, NWS, OEQ, ONT, PLA, PTM, QBE, QTI, RCU, RFL, RHG, RNY, ROC, SDG, SDI, SFC, SGN, SGT, SHL, SHV, SKI, SOF, SRH, SRV, STO, STW, TAN, TGP, TIM, TIMG, TIMHB, TRG, TRU, TWO, WBC, WDC, WHG and WRT This is not a recommendation. DATE OF PUBLICATION 17 February 2011

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