Company Profile – Woolworths Limited is a diversified retailer, which operates supermarkets, general merchandise stores, liquor, electronics, and speciality and discount department stores. The company provides petrol retailing and also operates hotels which include accommodation, pubs, food and gaming operations it offers private label and branded merchandise to its customers. The company operates more than 3000 retail stores under several banners such as Woolworths, Countdown, Thomas Dux, Cellarmasters, Caltex and BIG W. Australian Food and Liquor segment is engaged in the procurement of food and liquor and products for resale to customers in Australia. New Zealand Supermarkets segment is engaged in the procurement of food and liquor and products for resale to customers in New Zealand. Petrol segment is engaged in the procurement of petroleum products for resale to customers in Australia. BIG W segment is engaged procurement of discount general merchandise products for resale to customers in Australia. Hotels segment is engaged in the provision of leisure and hospitality services, including food and alcohol, accommodation, entertainment and gaming.

Analysis – There is improving momentum in Australian Food and Liquor sales with like for like sales increasing strongly and the like for like sales growth gap to Coles narrowing. Cost of doing business reductions achieved in 2^nd half of 2013 and more to come in financial year 2014 to support the EBIT margin expansion. While risks remain including execution on high capital cost Home improvement expansion, rising competition in Liquor from Aldi and poor results from Big W and Hotels, we note that the Australian food and liquor is the high cash generation division and comprises 83% of Earnings before Interest and Tax.

It is likely that like for like sales growth at WOW Australian food and liquor division will more closely match that of cowls through the Calendar year 2014 and there is an increasing chance that Woolworths will exceed Coles in at least one of the several quarters. An agreement with ACCC to cap fuel discounts at 4 cents per litre from 1^st January 2014 is likely to be less  impactful on Woolworths than Coles. It appears that likely that the rate of cost reduction and efficiency improvement is slowing at Coles, which will slow the amount of incremental funds available for promotion. WOW has been opening more supermarkets than Coles and this is likely to provide a tailwind for Australia’s Food and Liquor comparable store sales growth due to a higher rate of sales growth for stores maturing through their second and third years of operation. It appears that WOW’s marketing message has improved since the lows experienced in 2012.

Although the performance of masters has been underwhelming and there appears a good chance that earnings performance will be below expectations in FY14, the chance of a critical event risk in 2014 is low. In the absence of a pull out by Lowe’s or a decision by WOW management and board to cease the master’s initiative, the impact of master’s earning performance is likely to be relatively small. From a WOW perspective, Masters is relatively a small component of the group and there for losses and funding requirements can be absorbed and the incremental impact on group’s earnings is low. Lowe’s has an option to exit at any time, the earnings impact is low and the funding requirements from ongoing participation manageable. In the absence of management change at Lowe’s the venture is likely to be given more time.
 
Acquisition ambitions are modest. WOW has indicated publicly that it would seek an offshore acquisition under certain circumstances. The parameters describe a conservative acquisition which is moderate in scale to the balance sheet, a profitable business and not a turnaround story with growth opportunity. Its relatively ungeared balance sheet allows WOW the capacity to make a sizeable offshore acquisition without stretching conventional debt metrics.



Source – Thomson Reuters

Price		Price % Change
Close:	33.92 (05-Feb-2014)	3M:	(1.97%)
52 Wk High:	36.84 (24-Apr-2013)	6M:	1.62%
52 Wk Low:	31.53 (13-Jun-2013)	1Y:	6.73%

 

Dividend
Yield	4.053642	FY
	4.253112	5yr Av
Payout Ratio	73.70761	FY
	71.17935	5yr Av

 
Masters produced an EBIT loss of $123 Million in FY12 and $157 Million in FY13. The issues appear to be well known which are a high cost infrastructure, store opening costs and store currently trading at levels well below that needed to achieve break even. Lowe’s quarterly equity profits from associate investments suggest trading performances at Masters have not improved.

Customer count surveys are indicating some maturation benefit to Masters Stores. Surveys show improving traffic trend at masters stores during weekend trading - although the absolute level of performance remains well below that required to achieve store break even. Customer traffic levels are considerable higher during weekend periods than during the week relative to the main competitor Bunnings. Whilst the losses of Masters could be absorbed by WOW for some time, a very negative outcome occurs if there is appoint at which Lowe’s pulls out of the venture  or the WOW management  and board decide that the initiative is not going to work in the long term. These are material, low probability, critical event risks.

We believe that the chance of Lowe’s exiting the venture under current management is low provided that the cash requirements to fund losses do not grow materially beyond current levels. A change in management at Lowe’s would probably result in the joint venture commitment being reviewed more quickly.

WOW (AUD, Millions)	2013	2012	2011	2010	2009
Total Revenue	58,674	54,916	52,746	51,964	49,698
Gross Profit	15,604	14,322	13,559	13,303	12,620
Total Operating Expense	55,459	51,852	49,753	49,094	47,072
Operating Income	3,215	3,064	2,993	2,871	2,626
Net Income Before Taxes	3,215	3,064	2,993	2,871	2,626
Provision for Income Taxes	960	885	869	833	766
Net Income After Taxes	2,255	2,179	2,124	2,038	1,860

 

WOW	Industry Median	2013	2012	2011	2010	2009
Profitability
Gross Margin	25.0%	26.7%	26.1%	25.8%	25.7%	25.4%
EBITDA Margin	6.9%	7.9%	8.0%	7.8%	7.5%	7.2%
Operating Margin	4.7%	5.5%	5.6%	5.7%	5.5%	5.3%
Earning Power
Pretax ROA	8.8%	14.7%	14.5%	15.2%	16.1%	16.0%
Pretax ROE	22.3%	37.3%	38.8%	39.5%	39.9%	41.0%
Liquidity
Quick Ratio	0.55	0.29	0.31	0.32	0.25	0.24
Current Ratio	0.90	0.91	0.86	0.79	0.73	0.76
Leverage
Assets/Equity	2.75	2.46	2.64	2.74	2.44	2.51
Debt/Equity	0.27	0.49	0.58	0.64	0.47	0.47

 
The Victorian government has announced changes to the taxation of electronic gaming machine revenue increasing tax receipts in FY15 by A$81.1 Million as it returns to the historical average of electronic gaming machine revenue.  Given the productivity of the EGM’s it operates we expect WOW to be impacted by more than its share of EGM number. These changes indicate the heightened regulatory risk for the hotels division.
 
The quantum of increased taxation that WOW contributes following the increased rate of taxation in Victoria is unclear as the net machine revenue per day is unknown and hence the rate of tax it pays across its EGM’s is unknown. However WOW and specifically ALH is a very capable operator of EGM’s and is likely to be more skewed to the higher tax rates regime and have if any EGM’s paying the lowest tax rate. The WOW hotels division has been a strong growth business for the company and generates high margins largely due to the high gross margins in gaming.

We believe there is improving momentum for WOW in Australian Food and Liquor. There are cost of doing business reductions achieved in 2^nd half of 2013 and more to come in FY2014. While risks remain including expansion of the home improvement business and poor results from BIG W. we note the high cash generation from Australian Food and Liquor. We would be putting a BUY on WOW at the current price.
 

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