Sue Mitchell

Retail spending is stuck in first gear but you wouldn’t know it from the share price of  Australia’s largest retailer, Woolworths.

Woolworths stock has climbed 32 per cent this year and total shareholder returns are up 37 per cent, beating the S&P/ASX index by 12.4 per cent.

Not even a $200 million to $300 million wage underpayment scandal, which will dent bottom line profits this year, has disrupted the retailer’s momentum, with the shares reaching a record $39.37 earlier this week,

With almost 80 per cent of earnings from food and groceries, Woolworths is immune from a recession. Patrick Scala

The share price gains have been underpinned by demand from investors seeking defensive earnings amid growing fears about the strength of the Australian economy.

With 78 per cent of earnings from food and groceries in Australia and New Zealand,  Woolworths is arguably better placed than any stock (other than archrival Coles) to withstand a recession.

“Food retail is a bit different to most retail,” says Alphinity Investment Management fund manager Bruce Smith. “People always need to buy food whereas you can put off buying a new TV for a period of time.”

Retail food sales have risen an average 3.8 per cent a year over the last 10 years,  underpinned by population growth and a shift to premium products and services, and these drivers are expected to continue for the foreseeable future.

Drought-driven price hikes on the way

One element that has been lacking from the mix over the last 10 years is food price inflation –  prices fell almost every year between 2009 and 2019 due to intense competition between Woolworths, Coles and Aldi.

But food prices are starting to creep upwards as the major retailers pass on higher wholesale prices fuelled by the drought.  This might not be good for consumers’ hip pockets but it’s good news for food retailers, helping to boost sales and cover rising operating costs.

Woolworths isn’t immune from tough times – earnings fell almost 40 per cent between 2014 and 2017 as the retailer invested about $1 billion into prices and service to regain market share from Coles.

Woolworths shares dropped 42 per cent and it took until August for the shares to fully recover lost ground.

While Woolworths’ general merchandise business, Big W, is still losing money, profit upgrades have exceeded downgrades over the last year. “The momentum is on their side,” says Smith.

Woolworths’ underlying earnings before interest and tax rose 5 per cent in 2019.  Analysts are forecasting 3.4 per cent growth in 2020, when the company saw higher costs from a new enterprise agreement, and 6 per cent growth in 2021, according to Bloomberg consensus forecasts.

After gains of more than 30 per cent this year Woolworths shares are trading on a multiple of 27 times forecast earnings per share – a premium to the market and well above its historic price earnings multiple.

Analysts are divided about the outlook.

Jefferies analyst Michael Simotas, who has a buy recommendation and $42.50 a share price target, says industry conditions are favourable. He expects Woolworths to continue to take market share, while he says the threat from newcomer Kaufland is overstated.

Woolworths’ real like-for-like sales growth (excluding inflation) has outpaced that at Coles almost every quarter for two years, jumping 6.3 per cent in the September quarter while Coles’ real like-for-like sales fell 1.3 per cent.

“With the emergence of inflation, we think that both Coles and Woolworths can do well,” Simotas said in a recent report.

“While they are not cheap on any measure, they generate strong, stable cash flows and after a relatively difficult decade, we believe food retail industry conditions are improving.

“In the current environment where yields are low, market valuations are stretched and macro conditions are uncertain, we believe the market will continue to prescribe a considerable premium to the supermarkets.”

However, nine other analysts who cover the stock are neutral or have underperform ratings and the average  12-month price target is $33.66.

One factor that’s been helping to support Woolworths’ share price at a time when many analysts believe it’s overvalued is the imminent merger of the retail liquor, hotel and gaming businesses and a subsequent demerger through a sharemarket listing or trade sale.

“People think there might be a bit of value generated by the demerger  –whether that’s the case or not remains to be seen,” says Smith.

Bank of America Merrill Lynch analyst David Errington says the deal will be positive for the drinks business and UBS analyst Ben Gilbert says the proposal will be accretive for Woolworths shareholders.

“We believe the demerger/sale of Endeavour Group could see Woolworths undertake further capital management in 2020,” says  Gilbert.

Investors are no doubt looking at the $16 billion in value created through Wesfarmers’ demerger of Coles a year ago and hoping one plus one equals more than two.

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