CFA Institute Research Challenge Hosted by: CFA Society Sydney, Australia The University of Sydney Woolworths Australia Limited (WOW.ASX) Food Fight: The New Reality for Australian Grocers We initiate coverage on Woolworths Australia Limited (WOW.ASX) with a SELL recommendation and price target of $29.27, representing a 16.5% downside from the current price of $35.07. The Australian grocery market is re‐fragmenting and the period of oligopolistic consolidation which SYDNEY UNIVERSITY RESEARCH GROUP historically fostered WOW’s growth is drawing to a close. As Management has failed to implement strategic growth opportunities in the wake of increased competition and a resurgence in discount grocers, we do not see support for the current price. SUPERMARKETS | CHANGING OF THE GUARD SELL ‐ Industry re‐fragmentation represents a material threat to WOW’s core Food and Liquor (F&L) WOW.ASX segment (76% of sales). Stagnant real wage growth and heighted consumer price awareness GICS Industry: Food & Staples Retailing have acted as catalysts for the bifurcation of Australian grocery expenditure. Instead of weekly ‘one‐stop shops’, consumers are increasingly making bulk‐value purchases at discount GICS Sector: Consumer Staples grocers (ALDI) and periodically shopping at specialist retailers (Harris Farm Markets). We do Target Price: 29.27 not believe WOW’s ‘all‐in‐one’ model is sufficiently positioned to accommodate this shift in Last Price 19/09/2014 35.07 consumer demand. ‐ The Australian consumer’s appetite for discount supermarkets, once fulfilled by Franklins, is 52 week high 38.92 now being satiated by ALDI. Buoyed by a resurgence in private‐label products, the German 52 week low 32.42 grocer has gained ~10% market share since 2001 and outperforms all Australian competitors Market capitalisation ($bn) 44.06 on ‘known value indicator’ metrics. As ALDI succesfully executes an aggressive expansion Shares (m) 1,248 strategy, we expect material erosion to WOW’s 39.5% market share. CAPITAL MANAGEMENT | DESTROYING SHAREHOLDER VALUE ‐ Management has failed to drive new sources of growth. Despite facilitative negative working capital from the scaled supermarket business, WOW has engaged in projects that distract from its core business: > Masters: WOW has fundamentally misunderstood the Australian Home Improvement market. In misapplying Lowes’ American experience, the Master’s business has Price History Rebased persistently failed to meet growth expectations; posting an FY14 loss of $169m. In the absence of renewed guidance from Management, and noting it took Bunnings decades to 2.0 build a 17% share of the fragmented hardware market, we do not expect Master’s to materially contribute to profit until at least FY17. 1.5 > Premium Services: We do not see value in the roll out of in store services such as sushi and pizza bars, which serve to (1) increase Woolworths’ cost of doing business (up 20bp 1.0 to 20.9% FY14) and (2) adversely impact price perception, on which Woolworths trails Coles and ALDI. 0.5 > Online Retail is undoubtedly an important market trend. However, as it only comprises 3% of F&L sales, Mercury Two disproportionately focuses on enabling “click and collect”. 0.0 FY09 FY10 FY11 FY12 FY13 FY14 SUPPLY CHAIN DECAY | IS THE “VIRTUOUS DOUBLE LOOP” SLOWING? ‐ Supply chain reforms are a necessity. FY14 F&L Inventory DSO have risen to 34.1 (excl. WOW ASX200 Masters), a level not seen since FY03. Improving inventory turnover is critical, as interest free Source: Bloomberg gearing is created from the timing gap between customer and supplier payments. Slowing inventory turnover impacts stock freshness and limits WOW’s ability to achieve volume‐ driven productivity gains. With project leader Julie Coates leaving 10 months in to the 5 year reform, we are concerned for effective execution of Mercury Two. Total Area and Return on Funds Employed VALUATION | 16.5% DOWNSIDE 2,600 32% $m AUD FY13 FY14 FY15 FY16 FY17 31% Revenue 58,516 60,773 63,786 65,780 67,891 '000 2,500 2,400 30% Gross Profit 15,762 16,478 17,292 17,695 18,127 sqm 29% EBITDA 4,619 4,772 4,946 4,893 4,841 2,300 Area 28% NPAT 2,359 2,459 2,545 2,441 2,363 2,200 27% Gross Margin 26.9% 27.1% 27.1% 26.9% 26.7% 2,100 26% Net Margin 4.0% 4.0% 4.0% 3.7% 3.5% LT Debt to Assets 19.2% 17.1% 15.9% 14.6% 13.3% 2,000 25% Net Interest 12.3x 14.5x 15.3x 15.1x 15.1x 1,900 24% Return on Equity 25.3% 23.3% 22.0% 19.4% 17.4% FY10 FY11 FY12 FY13 FY14 EPS ($) 1.91 1.91 2.03 1.93 1.86 Total Area (LHS) ROFE (RHS) Source: Company Reports BUSINESS DESCRIPTION Revenue Contribution FY14 BUSINESS SNAPSHOT | OPERATIONS 2.5% 2.4% Woolworths Australia Limited (ASX: WOW) is Australia's largest retailer. Established in 1924 and 7.2% headquartered in Sydney, WOW has over 180,000 employees and serves 28 million customers a week. The business operates in Australia and New Zealand across the following segments: 11.6% F&L Petrol Food & Liquor: is Woolworths’ largest segment; generating $41.17bn in revenue (76.3% of total BIGW sales). WOW operates full‐service, medium‐size supermarkets with around 45,000 SKUs. Home Approximately 15% of total sales are derived from private label goods. This is in stark contrast to Hotels ALDI, who stocks approximately 1500 SKUs, 90% of which are private label. Within Australia, WOW 76.3% has 39.5% grocery market share, operating 931 supermarkets and a further 11 trading as Thomas Dux. In New Zealand (FY14 Sales of $5.19bn), Woolworths operates 171 Countdown supermarkets. Source: Bloomberg, Company Reports In addition, WOW is Australia’s largest liquor retailer, operating Australian liquor retailers Dan Murphy’s, BWS and Cellarmasters. Currently, 3% of food and liquor sales are generated online ($1.2bn). This is expected to change however, following increased investment in online capacity, Earnings per Share services such as “click and collect” as well as dark stores. 2.07 1.90 1.97 Fuel: WOW controls 24% of Australian fuel retailing, both independently (502 stations) and 1.76 1.79 1.65 under a joint venture with Caltex (131 stations). Petrol sales generated $7.06 billion in revenue in FY14 (11.6% of group sales). Home: WOW operates within the Home Improvement Industry through wholesale provider Danks and retail providers Home Hardware and Masters. Home generated $1.53bn in FY14 sales, (2.5% of group sales) and controlled 7% market share. In FY12, WOW established Masters in partnership with US‐owned Lowes (1/3rd ownership). The business is yet to achieve scale, with a ‐ FY10 FY11 FY12 FY13 FY14 FY15E $169m EBIT result and no new breakeven guidance. Notably, Lowes holds a put option through Source: Bloomberg, SURG Estimates which it can divest its Masters holdings at fair value. Hotels: Through the ALH Group WOW is Australia’s largest pub operator (329 locations). Hotels are WOW’s most profitable segment, contributing $1.47bn in FY14 sales with an EBIT/Sales ratio Group EBITDA Margin of 18.71%. In addition, WOW is Australia's fourth largest owner of poker machine licenses. Hotels provide liquor retailing rights in Queensland, where liquor licenses are attached to venues. 7.92% 7.74% 7.73% General Merchandise: Through discount retailer Big W, WOW stocks a range of products from 7.44% toys to clothing apparel. The business contributed $4.35 billion in sales in FY14 across 182 7.09% locations. In an attempt to improve profitability, WOW is consolidating Big W and NZ based EzyBuy. 6.61% Financing: WOW distributes personal insurance through HFS and credit cards via HSBC. The business segment has recently been revamped as ‘Woolworths Money’, gearing up to compete with Coles credit cards. BUSINESS SNAPHOT | COMPANY STRATEGY FY10 FY11 FY12 FY13 FY14 FY15E WOW’s strategy is built on four key pillars, (1) Extend leadership in food and liquor, (2) Act on the Source: Bloomberg, SURG Estimates firm’s portfolio (3) Build new growth businesses and (4) Increase investment in existing capabilities. (1) Extend leadership in food and liquor: WOW aims to stem the loss of F&L market share through improving consumer price perception and via new service offerings. A key component of this strategy is the Everyday Rewards loyalty program. Through targeted discounts, WOW aims to encourage customer retention and improve the perceived competitiveness of its offering. Group Return on Invested Capital Additionally, WOW continues to employ significant capital expenditure in rolling out new stores; 11.17% 30 new supermarkets and 10 new liquor stores were opened in FY13. Increased competition from Coles and ALDI, however, has seen WOW’s ROIC steadily decline over the past five years. 10.60% (2) Act on the firm’s existing portfolio: BIG W has been materially affected by the growth in 10.27% online retail. In response to flat and declining sales, WOW acquired NZ online retailer “EzyBuy” and 10.10% 10.16% 9.96% is in the process of integrating this business with Big W. Management has advised that restructuring costs will be incurred in the short run. Additionally, consistent with WOW’s policy of entering into long term leases rather than holding property assets, WOW announced the sale and leaseback of 54 freehold properties for $603 million in September 2014. (3) Build new growth businesses & (4) Increase Investment in Existing Capabilities: Masters has FY10 FY11 FY12 FY13 FY14 FY15F underperformed expectations since its establishment in FY12. WOW continues to invest in this business in an attempt to achieve scale.