Woolworths: Aussie Giant Overvalued

Summary

• Woolworths Group Ltd's stock price has been in a strong uptrend since mid 2016 and is once again nearing record highs.
• This has left Woolworths with a record high forward P/E ratio of over 23, despite stagnant/falling revenue over the past 5 years.
• With competition in the sector increasing and the Australian economy worsening, Woolworths' extreme valuation looks vulnerable.

Note: This article refers to the ASX listed Woolworths Group Limited (OTCPK:WOLZY) (WOW.AX). All amounts listed are in AUD unless otherwise specified.

The Stock

Woolworths Group Ltd is an Australian conglomerate engaged in retail operations, with segments including food and petrol, New Zealand Supermarkets, Endeavour Drinks Group, BIGW, and Hotels. Since reaching multi-year lows in mid 2016 on the back of fears over increasing competition and poor management, the stock has been bid up over 45%, nearly reaching its all-time highs of $37 yet again.

(Source: Google Finance)

However, its current valuation is far too optimistic considering the fact that the fears which caused the massive sell-off in 2014-2015 have not been comprehensively addressed, while the ability of Woolworths' operations and growth is questionable at best, in terms of trying to justify the stock's current valuation. At its current price, the market has bid Woolworths' forward P/E to an all-time high.

(Source: Natrade/Reuters)

This extreme valuation (compared to the average ASX200 PE ratio of approx. 16) suggests that the market is expecting a significant turnaround in Woolworths' near-term future. However, recent history suggests this is unlikely, as revenue has been stagnant/falling for several years.

(Source: Yahoo Finance)

While at first glance, 2017's improved result seems highly promising, this is only due to the sale of the exceptionally poorly conceived and executed Masters hardware store experiment which caused a lag in 2016's results, and it's not a sign of any significant turnaround in underlying performance. Per Citigroup:

Based on supplier feedback, Woolworths is experiencing a slowdown in sales momentum. We forecast a drop from 4.5% in 3Q18 to 3.3% in 4Q18e, as the company laps 6.4% LFL sales growth in 4Q17."

Woolworths is expected to deliver same-store sales growth ahead of main rival Coles (1.7% exp growth in 4Q18); however, Coles' performance is expected to turnaround in the medium term, eating into Woolworths' market share. Coles is also about to start its 'Little Shop' promotion in the current quarter, which has proven its value in overseas markets (the 'Little Shop' is a giveaway of well-known miniature branded products for every $30 spent). German grocery giant Aldi now has over 500 stores across Australia and its ongoing expansion is expected to earn the company 9.2 percent of the supermarkets and grocery stores industry by the end of 2017-2018.

Though Amazon entered the Australian market in December 2017, the US ecommerce giant is yet to launch its AmazonFresh brand here. Revenue in the online grocery sales industry is forecast to grow at an annualised 12.4 percent over the next five years. (Source: Inside Retail)

With the rise of Aldi and Costco (COST) and the expected entry of AmazonFresh and Kaufland, Australia's grocery sector is going to become even more crowded in the medium term, threatening Woolworths' existing market share.

Woolworths also intends to spin-off its petrol business. Management believes this would be a positive as they claim the free cash brought on by the sale would enable the exploration of other strategies:

Woolworths still intends to pursue an IPO or sale of its petrol business as retaining it was not optimal for long-term success and the money released from exiting could be put to better use. (Source: News.com.au)

However, if the cash really could be put to better use, Woolworths has the existing balance sheet capacity to pursue any worthwhile ventures without ridding itself of an important revenue generating segment.

As such, even with the optimistic revenue growth forecast by analysts, I cannot see Woolworths maintaining its current extreme valuation in the long term.

(Source: Nabtrade/Reuters)

Declining Domestic Economy

Woolworths' record high valuation also looks questionable in the face of a declining domestic economy (caused by a declining housing market). Mortgage serviceability, credit supply, and house price expectations are all now falling, causing the majority of market participants to forecast falls for Australian housing over the short term.

We expect values in Sydney to fall between 5 to 10 percent over an 18 to 24 month period. Tighter credit policies have hurt Sydney more than other markets because it is more exposed to investors. At one point Sydney had more than 60 percent investors. (Source: Australian Financial Review)

Morgan Stanley's forward-looking housing model has reached a new historical low at -1.0 for the June quarter.

(Source: MacroBusiness Australia)

The bank is warning that prices could slump by another 10 percent as all six key indicators in its housing model, including demand/supply balance to credit availability and house price expectations turn negative.

It is the latest in a string of pessimistic predictions from banks, brokers and investment analysts about prospects for the nation's property market as it rapidly descends from record price growth and unprecedented local and overseas' demand. (Source: Australian Financial Review)

The sector is at high risk of entering a negative feedback loop as investors are forced to sell properties at loss, and interest-only loan holders are unable to refinance as their properties enter negative equity.

(Source: RBA May 2018 Statement of Monetary Policy)

The rise in scheduled payments amounts to about $7,000 per year for the typical IO loan in the Securitisation Database (of around $400,000). For such households, this is a non-trivial sum. The effect on their consumption though will depend on the extent to which they have planned and provisioned for this predictable step-up in payments. (Source: RBA May 2018 Statement of Monetary Policy)

A declining economy would result in Woolworths struggling to sell any of its higher margin products, leading to a fall in profitability.

Technical Analysis/Charting

Woolworths' stock has been in a strong uptrend since mid 2016.

(Source: IG Markets/My Own TA)

This uptrend has stalled since price rebounded from the upper tier of the clearly identifiable upwards channel. This rebound provides a clear entry point for shorts to enter, as if price breaches both the 50- and 100-day moving averages, longs will begin to be liquidated, and price may accelerate to the downside.

(Source: IG Markets/My Own TA)

Risks

If Woolworths is successful in the IPO/spinoff of its petrol business, the resulting short-term volatility could cause a short squeeze/upwards spike. Traditional thinking would dictate that a severe decline in the domestic economy would also likely result in a sector rotation with investors entering traditionally defensive sectors. That would include Woolworths, but considering Woolworths' current premium valuation, the stock might still be very vulnerable.

Conclusion

Woolworths Group's current valuation is far too optimistic considering the lack of growth in Woolworths' operations over the past 5 years. With its forward P/E ratio at an all-time high in a declining economy, an opportunity has been created for short sellers to consider entering positions.

All investors must conduct their own due diligence on all investments and must take full responsibility for their own portfolio.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[James Hanshaw]

Australia has hardly been touched by online shopping yet. Amazon made a hash of some things there and my contacts in Australia - family members - laugh at the thought it will change anything in their way of life. Likewise they laugh at Aldi’s prospects. Australian has been so far removed from many things that have hit the rest of the world for so long, such as recessions, that the complacency there is hard to believe. No doubt management at firms like Woolworths are just as complacent and they will not know what hit them when the real world finally arrives.

Household debt is already among the highest in the world, the easy high paying jobs in the resources sector are going or gone. I sold my last investment there several months ago.

[Michael Turner]

Hi @James Hanshaw ,
Thanks for your comment! Absolutely agreed re the widespread complacency in Australian boardrooms/management teams. Many blue chips here are in for a shock in the not-to-distant future!