Buying the house brand

Woolworths broke above both the 200 period moving average (red line) and the downtrend line in place since October 2009 to surge higher. The most recent high touched was $28.89 on August 26. This rapid move higher has pushed the RSI into overbought territory, which is indicative of an exhaustive move on the upside. In the short term, we believe that Woolworths will retrace lower to retest the downtrend line and 200 period moving average at the $27.20 region before a resumption of the uptrend.

From the weekly chart, the recent advance encountered resistance at the upper symmetrical triangle. A convincing break above this level would see a test of the October 2009 high of $30.57 over the broader term. The recent buy signal on the weekly MACD is supportive of a breakout to the upside.

Net profit after tax growth of 10.1% was at the upper end of Woolworth’s 8-11% guidance range. At $2,020.8 million, the company has delivered another terrific result in its Food & Liquor division, even as some of its other businesses struggled a little in the difficult environment.

The company has announced a more vigorous share buy-back with a $700 million off-market buy-back to be completed in early October. This is in addition to the $375 million of shares repurchased on-market in the first half of the calendar year. When added to the $1.3 billion in fully franked dividends paid in the 2010 financial year, shareholders will have received almost $2.4 billion in just over 12 months.

The off-market buy-back is optional. Shareholders registered on 6 September 2010 will be entitled to sell some or all of their shares at discounts of 8-14% to the market price or the final tender price. The Australian Tax Office is indicating there will be a capital component of $3.08 with the balance being treated as a fully franked dividend. Shareholders will need to seek their own tax advice before deciding whether to participate. Shareholders who participate will still be eligible for the 2010 final dividend.

Woolworths increased its final dividend to 62 cents per share bringing the full year dividend amount to 115 cents per share. The dividend is fully franked and represents a payout ratio of 70.4%.

Fresh profit people

The 2010 financial year has been characterised by some quite intense competition in the supermarket industry, particularly in the fresh food category. Woolworths’ main competitor, Coles, has significantly improved its offering and has been chasing market share through an aggressive pricing strategy. Lower food inflation has exacerbated the situation making revenue growth very difficult to achieve. As prices have dropped in many categories, the volumes sold have soared putting pressure on suppliers and on the companies’ supply chain logistics.

The outcome, according to Woolworths, was an increase in market share. The company thinks Aldi may have ceded some of its recent gains in market share back to Coles, leaving Woolworths in front of the pack.

It’s hard to argue that Woolworths does not have the superior offering in terms of its stores relative to the competition. Coles has made good progress with its new format rollout but is still substantially behind Woolworths which is now unveiling its next generation of store format. The first of these was completed at Charlestown near Newcastle.

Total food and liquor sales for the year increased 5.1% to $34.6 billion with petrol adding a further $5.4 billion. Gross margin improved by 46 basis points (bps) while the cost of doing business decreased by slightly more than its annual target of 20bps. Operating profit (EBIT) therefore increased 13% to $2,592 million representing a margin of 6.45%, nearly 0.5% better than last year.

New Zealand supermarkets are beginning to show the early benefits of a more focused strategy. The re-branding of all stores to the Countdown format is 68% complete. Sales for the year increased 4.6% but operating profit margin of 4.7% indicates how much more improvement is possible in this division. Trading EBIT increased 17.3% in response to the better offering.

BIG W

Discount department stores across Australia have now all cycled out the cash stimulus payments from the government in 2009. The temporary boost to consumer spending has ended and the industry is back to its underlying state. That state indicates consumers are spending their money very carefully. A higher Australian dollar has also meant cheaper prices on imported goods. An entry level t-shirt that last year sold for $10, for example, is now selling at $7.

Again, the visible impact has been on Woolworths’ revenue line with sales declining 1.7% for the year. However, good cost control and a surge in volume of key items enabled BIG W to deliver a flat EBIT result of $200 million.

Consumer Electronics

The reformatting of the Dick Smith stores has been beneficial with the refurbished stores trading around 15% higher across the year. The higher Australian dollar also affected this business, even as unit volumes boomed. A year ago, Dick Smith did not stock flat screen televisions or computers. In 2010, it sold nearly 280,000 TVs and more than 250,000 computers.

Slightly more than half the store portfolio still needs to be reformatted, indicating a better outlook is possible for this division.

Hotels

Woolworths’ hotel portfolio reported an 18.9% decrease in EBIT as reduced trading hours in Queensland and changes to maximum bet and restrictions on ATMs in Victoria crimped turnover. This business also felt the cycling effect of the government cash payments.

Home Improvement

Woolworths will open its first home improvement store in 2011 as part of its 150 store portfolio. The division will obviously take several years before it makes a meaningful contribution to group profits but progress to date in obtaining sites is encouraging.

Strategy

Just why Woolworths attracts such a premium in its share price is a combination of impressive track record on earnings and its very focused strategy for the future. In short, management is very believable because of its track record.

The incremental gains it gets each year from its supply chain, pricing of goods from suppliers (domestic and foreign), lower cost of doing business and innovative fringe products such as financial services all adds up.

The company is constantly in search of better ways of conducting its business. The latest improvement program is called the Quantum Project. The name may have changed (from Project Refresh) but the targets are still the same – supply chain, procurement, work practices, global direct sourcing and support structures. Again, the benefits will be shared between shareholders and customers.

Woolworths is again guiding the market to expect net profit growth between 8% and 11% for the 2011 year.

Summary

The market has finally been given a stronger capital management program to better optimise the balance sheet. It has been slow coming but probably reflects the company’s caution throughout the difficult last two years.

There still seems to be no real shortage of organic growth within the core food and liquor business. Adding 15-20 stores each year represents about 3% floor space growth, while the liquor, general merchandise and consumer electronics businesses can also expand. The home improvement strategy is longer term but is finally underway.

Our view remains that Woolworths is an excellent company, but this view is shared by the market and is fully reflected in the share price.