Woolworths Limited (WOW) 26 July 216 Underperform Long road ahead remains $24.3 $17.5 Mark Wade mwade@taylorcollison.com.au +612 921 1331 Summary Market capitalisation (A$M) 31,74 Share price ($A) 24.3 52 week range ($A) 2.3-29.22 Valuation ($A) 17.5 Avg monthly volume (yr rolling; M) 95 Key Financials (incl. Home Improvement) Year end June 215A 216E 217E Sales revenue (A$M) 6,679 6,158 58,824 EBIT (A$M) 3,748 2,331 2,414 EBIT Margin (%) 6.2% 3.9% 4.1% EV / EBIT (x) 9.4 15.2 14.6 Adj net profit (A$M) 2,453 1,398 1,442 Basic EPS (cps) 195 19 113 EPS growth (%) -.6% -44.% 3.2% PE ratio (x) 12.4 22.2 21.5 Dividends (cps) 139 77 56 Div yield (%) 5.7% 3.2% 2.3% Payout ratio (%) 71% 7% 5% Return on equity (%) 23% 17% 17% Share Price Graph Share price (A$) 4 35 3 25 2 15 1 5 All Ords Index (rebased) Woolworths Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Operating Model to Depart from Status Quo Woolworths will incur a further $959M in restructuring costs in FY16, signalling a change in the status quo. The pace of new store openings will be halved in Australian Supermarkets, up to 69 underperforming stores closed across the group, and more existing stores refurbished. This follows sales per square metre and return on funds employed now being part of long term incentive payment decisions. EziBuy is likely to be sold and capital conserved, but there is no intention to raise equity. Customer attitudes have improved, which has preceded a return to positive growth in transaction counts and basket size in June. One could expect a return to positive same store sales growth in as little as six months from now. Management is to be applauded for deviating from the status quo. That said, the 8% rise in yesterday s share price looks overly optimistic. Our Concerns Of greater concern is that the underlying performances of Australian Supermarkets and General Merchandise appear to have deteriorated sharply in 4Q16. Forecast EBIT margin for Food, Liquor and Petrol in FY16 declined from around 5% to 4.66% four months later, equating to a 36% fall in segment EBIT, with no clear explanation as to how $1.25bn dissipated in one year. With sales growth remaining anaemic, we forecast a further 1% decline in segment EBIT in FY17 vs. market expectations of trough earnings in FY16. Despite the announced changes, Woolworths still faces a long road ahead. Management is only now beginning to grasp the scale of their problems, how far they will have to go to lure back customers, or how bad it could actually get. We anticipate the recovery process will take longer than expected to win back customers, mute any potential competitive response in an increasingly hostile environment, and stabilise profitability. What is Required? By our assessment, the past 18 months has achieved limited overall progress to address our 12 step roadmap to recovery, as set out in our earlier formal initiation report. Among other things, the company requires: (i) A distinct point of difference; (ii) A clear 5 year plan; and (iii) Better execution. With the shape and time required for a sustained recovery remaining underestimated by the stock market, investors should avoid the stock. A stock price below $17.5 per share, all other things being equal, is needed to compensate for the risk involved.
Woolworths Limited Page 2 of 1 Woolworths Limited Profit & Loss (A$M) Divisions Year end June 214A 215A 216E 217E 218E Year end June 214A 215A 216E 217E 218E Sales Revenue 6,773 6,679 6,158 58,824 59,976 Store Network (No.) Other Revenue 422 47 425 436 447 Australian Supermarkets 931 961 985 975 985 Total Revenue 61,195 61,86 6,583 59,26 6,423 Liquor 1,42 1,445 1,475 1,493 1,511 Cost of Goods Sold 44,719 44,4 44,881 44,85 44,973 Petrol 633 516 526 536 546 Gross Profit 16,476 16,687 15,72 15,175 15,45 New Zealand Supermarkets 171 177 182 186 19 Cost of Doing Business 11,74 11,885 12,275 11,772 11,822 General Merchandise 186 189 191 19 188 EBITDA 4,772 4,82 3,427 3,42 3,628 Hotels 329 33 332 334 336 D&A 996 1,54 1,96 989 1,55 Masters 49 58 EBIT 3,775 3,748 2,331 2,414 2,573 Home Timber & Hardware 28 44 Net Interest Expense 26 255 27 288 299 Thomas Dux 11 9 5 5 5 Pre-Tax Profit 3,515 3,494 2,61 2,126 2,274 Wholesale 754 732 281 282 283 Tax 1,57 1,48 618 638 682 Total Store Network 4,494 4,461 3,977 4,1 4,44 NPAT Normalised 2,458 2,446 1,443 1,488 1,592 Non-controlling Interests 7-8 45 46 47 Sales Revenue (A$M) Normalised Profit to Parent 2,452 2,453 1,398 1,442 1,545 Australian Supermarkets 35,563 36,93 36,16 36,92 36,453 Profit from Disc Ops Liquor 5,67 6,38 6,412 6,763 7,111 One-off Items -37-2,721 Petrol 7,65 5,632 4,555 4,666 4,777 Reported Profit to Parent 2,452 2,146-1,322 1,442 1,545 New Zealand Supermarkets 5,186 5,467 5,565 5,847 6,124 General Merchandise 4,352 4,16 3,853 3,95 3,919 Margins on Sales Revenue Hotels 1,472 1,475 1,511 1,551 1,591 GP 27.1% 27.5% 26.1% 25.8% 25.8% Masters 752 93 1,78 CODB 19.3% 19.6% 2.4% 2.% 19.7% Home Timber & Hardware 775 937 1,168 EBITDA 7.9% 7.9% 5.7% 5.8% 6.% Thomas Dux 64 59 43 31 32 EBIT 6.2% 6.2% 3.9% 4.1% 4.3% Unallocated -64-59 -43-31 -32 Normalised Profit 4.% 4.% 2.4% 2.5% 2.7% Group Sales Revenue 6,773 6,679 6,158 58,824 59,976 Change on PCP Same Store Sales Growth (%) Operating Revenue 2.7% -.2% -.9% -2.2% 2.% Australian Supermarkets.% -3.5% -2.3% -.7% 1.% EBIT 3.3% -.7% -37.8% 3.5% 6.6% Liquor.1% 4.2% 3.6% 3.9% 3.9% Normalised Profit to Parent 4.1%.1% -43.% 3.2% 7.1% Petrol 4.% -1.7% -1.8%.5%.5% New Zealand Supermarkets.3%.9% 1.5% 2.5% 2.5% Per share data General Merchandise -3.1% -7.2% -7.2% 1.1% 1.1% Year end June 214A 215A 216E 217E 218E Hotels 1.% -.4% 2.% 2.% 2.% Masters -18.3% -7.5% 2.5% -1.% -1.% Basic EPS 196 195 19 113 121 Home Timber & Hardware -4.9% -9.4% 2.% -1.% -1.% EPS growth 3.2% -.6% -44.% 3.2% 7.1% Thomas Dux 2.5% 2.5% 2.5% 2.5% 2.5% Ordinary DPS 137 139 77 56 6 Group -.2% -1.4% -9.1% 7.6% 1.6% Payout ratio 7% 71% 7% 5% 5% FCF per share 171 152 181 95 79 EBIT (A$M) Weighted Avg SOI (m) 1,248 1,257 1,279 1,279 1,279 Australian Supermarkets 2,95 2,996 1,747 1,534 1,64 Liquor 329 36 385 372 356 Petrol 89 84 57 7 72 Balance Sheet (A$M) New Zealand Supermarkets 271 33 292 292 36 Year end June 214A 215A 216E 217E 218E General Merchandise 153 114-35 36 87 Hotels 275 235 227 233 239 Cash 923 1,333 1,16 993 625 Masters -176-246 -248 Receivables 926 885 872 85 869 Home Timber & Hardware 7 21 26 Inventories 4,693 4,872 4,34 4,227 4,312 Thomas Dux 3 2 2 1 1 Other 633 57 57 57 57 Unallocated -126-121 -121-125 -128 Current Assets 7,175 7,661 6,96 6,641 6,377 Group EBIT 3,775 3,748 2,331 2,414 2,573 PPE 9,61 1,62 9,26 1,257 11,669 EBIT Margin (%) Intangibles 6,335 6,245 5,562 5,464 5,363 Australian Supermarkets 8.3% 8.3% 4.9% 4.3% 4.5% Other 1,95 1,369 1,369 1,369 1,369 Liquor 5.9% 6.% 6.% 5.5% 5.% Non-Current Assets 17,3 17,676 16,138 17,9 18,41 Petrol 1.3% 1.5% 1.3% 1.5% 1.5% New Zealand Supermarkets 5.2% 5.5% 5.3% 5.% 5.% Payables 6,6 6,181 6,148 6,39 6,161 General Merchandise 3.5% 2.8% -.9%.9% 2.2% Interest bearing liabilities 22 1,645 1,745 1,845 1,945 Hotels 18.7% 15.9% 15.% 15.% 15.% Other 1,332 1,342 2,267 2,267 2,267 Masters -23.4% -26.4% -23.%.%.% Current Liabilities 7,558 9,169 1,16 1,151 1,373 Home Timber & Hardware.9% 2.2% 2.3%.%.% Thomas Dux 4.% 4.% 4.% 4.% 4.% Interest bearing liabilities 4,136 3,79 3,79 3,79 3,79 Unallocated -197.6% -23.5% -283.7% -399.1% -41.% Other 1,62 1,768 1,87 1,87 1,87 Group EBIT 6.2% 6.2% 3.9% 4.1% 4.3% Non-Current Liabilities 5,738 4,848 4,886 4,886 4,886 Cash Flow (A$M) Net Assets 1,99 11,321 7,997 8,694 9,519 Year end June 214A 215A 216E 217E 218E Contributed equity 4,631 4,99 4,99 4,99 4,99 Gross cashflow 4,973 4,711 3,976 3,391 3,646 Retained profits 5,423 5,83 3,36 3,718 4,528 Cash net interest paid -338-31 -327-346 -358 Reserves 198 95 95 95 95 Tax paid -1,163-1,56-618 -638-682 Non controlling interests 273 298-232 -217-21 Net operating cash flows 3,473 3,345 3,3 2,47 2,65 Total Equity 1,525 11,132 7,89 8,55 9,331 Purchase PPE & intangibles -1,364-1,577-1,322-1,683-2,1 Net payments for prop develop -523-596 -5-2 -26 Other -145 839 Net investing cash flows -2,31-1,334-1,372-1,883-2,36 Balance Sheet Analysis Net borrowings -67-26 1 1 1 Year end June 214A 215A 216E 217E 218E Dividends paid -1,523-1,567-1,51-791 -767 Other 219 163-43 Net debt to EBITDA.7.7 1.1 1.2 1.2 Net financing cash flows -1,372-1,611-1,831-691 -667 Net debt to equity 33% 3% 47% 46% 47% EBIT interest cover 14.5 14.7 8.6 8.4 8.6 Change in cash held 69 4-173 -167-368 Cash at beginning of period 849 923 1,333 1,16 993 Parent share of NPAT 1% 1% 97% 97% 97% FX effect 4 1 Tax efficiency 7% 7% 7% 7% 7% Cash at end of period 923 1,333 1,16 993 625 Interest burden 93% 93% 88% 88% 88% EBIT margin 6% 6% 4% 4% 4% Free Cash Flow Analysis (A$M) Asset turnover 251% 239% 261% 248% 242% Year end June 214A 215A 216E 217E 218E Financial leverage 23% 228% 295% 279% 266% Group share of equity 13% 13% 97% 98% 98% EBITDA 4,772 4,82 3,427 3,42 3,628 Return on Equity 24% 23% 17% 17% 16% Less: Cash Net Interest Paid -338-31 -327-346 -358 Less: Tax 1,163 1,56 618 638 682 Return on Assets 16% 15% 1% 1% 1% Less: Capex 1,887 2,173 1,372 1,883 2,36 Less: Change in WC -79-28 -548 11-18 Return Capital Employed 26% 25% 2% 19% 18% Free Cash Flow 2,14 1,912 2,312 1,217 1,15 Underperform Taylor Collison Limited 26 July 216
Woolworths Limited Page 3 of 1 Woolworths Limited Statistics & Valuation Underperform Valuation Ratios at Current Share Price Year end June 214A 215A 216E 217E 218E Date 26-Jul-16 EV / Sales.6.6.6.6.6 Share price $24.3 EV / EBIT 9.4 9.4 15.2 14.6 13.7 DCF valuation (probability wgt avg for 3 scenarios) $17.25 PE Ratio 12.4 12.4 22.2 21.5 2.1 SOTP valuation (as above) $17.76 Dividend Yield 5.6% 5.7% 3.2% 2.3% 2.5% Average valuation $17.5 Price / FCF 14.2 16. 13.4 25.5 3.6 Premium/(discount) to share price -28.% Price / BV 2.8 2.6 3.7 3.4 3.1 DCF Assumptions Ratios at Valuation Year end June 214A 215A 216E 217E 218E Risk-free Rate 5.% Pre-tax Cost of Debt 7.% EV / Sales.4.4.4.5.4 ERP 3.% After-tax Cost of Debt 4.9% EV / EBIT 7.1 7.2 11.5 11.1 1.5 Equity Beta.8 Gearing (ND/ND+E) 25.% PE Ratio 8.9 9. 16. 15.5 14.5 Cost of Equity 7.4% Unlevered Beta.6 Dividend Yield 7.8% 7.9% 4.4% 3.2% 3.4% WACC 6.8% Terminal Growth Rate 2.5% Price / FCF 1.2 11.5 9.7 18.4 22. Price / BV 2.2 2. 2.9 2.7 2.4 Major Shareholders Peer Valuations - PE Ratio Shares Holding Year end June FY-1 FY+ FY+1 FY+2 FY+3 M % HSBC Custody Nominees 27.4 16.2% MTS (3 Apr) 8.1 1.7 12.2 13.3 11. JP Morgan Nominees 128.9 1.1% WES 21.5 19.5 21. 19.5 18.4 National Nominees 124. 9.7% na na na na na Perpetual Limited 64.2 5.% na na na na na Citicorp Nominees 43.6 3.4% na na na na na BNP Paribas Nominees 35.4 2.8% Average: 14.8 15.1 16.6 16.4 14.7 Management Shareholders Peer Valuations - EV / EBIT Shares Holding Year end June FY-1 FY+ FY+1 FY+2 FY+3 M % Gordon Cairns (Non-Executive Chairman).1.% MTS (3 Apr) 7.7 8.4 9.3 8. 7.9 Brad Banducci (CEO).1.% WES 14.2 13.5 14.9 13.6 12.9 David Marr (CFO).1.% na na na na na Richard Dammery (Chief Legal Officer & Co. Secretary)..% na na na na na na na na na na Average: 1.9 11. 12.1 1.8 1.4 Current Earnings Guidance from Management Peer Valuations - Dividend Yield Year end June FY-1 FY+ FY+1 FY+2 FY+3 FY16 underlying EBIT from continuing operations of $2,55M to $257M (excludes Home Improvement) MTS (3 Apr) 3.%.% 2.3% 5.6% 5.6% WES 7.1% 4.7% 4.8% 4.9% 4.4% - - - - - - - - - - - - - - - Average: 5.1% 2.4% 3.6% 5.2% 5.% Taylor Collison Limited 26 July 216
Woolworths Limited Page 4 of 1 Operating model to finally depart from the status quo Overview of the announcement, highlighting the notable positives Woolworths has updated investors on the outcome of a review of its operating model, signalling a lauded change in the status quo. This involves a further $959M in restructuring costs (or $766M after tax) to be incurred in FY16. Specifically, the pace of new store openings will be halved in Australian Supermarkets, up to 69 underperforming stores closed across the group, and more existing stores refurbished (82 Australian Supermarkets in FY17, and possibly 15 in each of FY18 and FY19). This follows sales per square metre and return on funds employed, metrics both largely overlooked in the past (Figure 1), now being featured in the decision to award future long term incentive payments to senior managers. Figure 1. Changes in: (a) Food & Liquor sales density and store size; and (b) group return on capital employed Sales density ($'k per sqm) 18 16 14 12 1 8 6 4 2 Sales density (LHS) Store size (RHS) Declining 8 yrs Store size (k sqm) 91 96 1 6 11 16E 1.6 1.4 1.2 1..8.6.4.2. Group return on capital (%) 5% 4% 3% 2% 1% FY5: 49.7% % 91 96 1 6 11 16E FY16: 17.9% Additionally, apparel retailer EziBuy, which was acquired for $37M on 3 August 213, had its carrying value cut by a staggering $39M to just $3M, and divestment now being considered (but evidently BIG W will be retained, at least for now). Combined with other initiatives to conserve capital (dividend reinvestment, reduce capex, lower working capital), management does not intend to raise equity. In the Australian Supermarkets business, customer attitudes have improved, with 75% of respondents in Voice of the Customer surveys satisfied at end of June (although that is down from a target of 8% for June and 78% recorded in May as reported at last month s AFGC Conference; although up from 72% in April and 75% in December last year, as noted at the 1H16 results). Transaction counts and basket size returned to positive growth in June. Though so far the reduction in shelf prices means same store sales growth has remained negative. Optimistically, one could expect a return to positive same store sales growth in as little as six months from now (i.e., 3Q17). For the first time, the performance of liquor will be disclosed separately at the FY16 results. We surmise this will make liquor a clearer takeover target, and enable the performance of the Supermarkets business to be better ascertained (though management intends the combine the results for Supermarkets and Fuel). Overall, the board and management are to be applauded for deviating from the status quo view expressed in February. At the time we noted our reservations that this was unlikely to be enough, so these changes are welcomed. That said, we think the 8% rise in the share price yesterday is an overly optimistic reaction. Our concerns Of greater concern is that the underlying performances of Australian Supermarkets and General Merchandise appear to have deteriorated sharply in 4Q16, which will no doubt persist into FY17 as operating deleverage plays out. In particular, in February management provided earnings guidance for an EBIT margin of around 5% in Food, Liquor and Petrol combined in FY16. That now looks like becoming 4.66% on our revised estimates, Taylor Collison Limited 26 July 216
Woolworths Limited Page 5 of 1 equating to a 36% fall in segment EBIT from $3.44bn last year to $2.19bn, with no clear explanation as to how $1.25bn dissipated in one year. With sales growth remaining anaemic, we forecast a further 1% decline in segment EBIT to $1.98bn in FY17 (based on a 4.16% blended margin) vs. market expectations of trough earnings in FY16. Broadly speaking, Woolworths turnaround remains in its early stages, with risk of bad news eventuating over the next year or so. The announcement made little reference to cash flow and net debt impacts. Further, it contained little in the way of detail regarding the previously foreshadowed plans to exit Home Improvement. This includes a possible valuation agreed with JV partner Lowe s, which itself expects to salvage US$4M or A$555M vs. Woolworths previous assessment of nil. How does this stack up against out roadmap to recovery? Our formal initiation report How Woolworths lost its way, and how to turn it around of 13 January proposed a 12 step roadmap for recovery. Of the 12 steps, three were deemed paramount, while another nine were ideal, for it to create sustainable foundations necessary to succeed in an increasing competitive landscape. By our assessment, limited overall progress has been made against our roadmap to recovery since Banducci s arrival nearly 18 months ago. We sense that only now management are beginning to grasp the scale of their problems, how far they will have to go to lure back customers, or how bad it could actually get, as informed by overseas examples. Yet preparedness is needed for more far-reaching changes, undertaken now to avoid a drawn-out dire outcome. As such, Woolworths faces a long road ahead. Essential steps 1. Clearly articulate what they stand for develop a clear customer proposition for Woolworths Supermarkets and BIGW that is distinct from competitors, then build the brand and offering around it. Unresolved (challenged in Fresh by improvements from ALDI and Coles). 2. Bold and decisive decision making a clear five year plan that makes hard choices and prepares for a new era. Some progress (Masters and possibly EziBuy to go; BIGW to remain, for now; Supermarkets turnaround requires 3-5 years, but details still largely scant). 3. Better execution improve in-store execution, particularly inventory levels and store appearance. Some action (eg. lift in store refurb activity, yet requires 138 per year vs. target of 8 in FY16 (that now seems unlikely to be met, with just 47 conducted in the first 9 months) and 82 (was 12) in FY17. In reality, a larger figure again is needed to overcome a shortfall of 457 stores since 27 - Figure 2). Other than a desire to seek optimal learnings, it is still possible Woolworths is constrained by capital. Figure 2. Changes in store refurbishment activity: (a) Woolworths Supermarkets, and (b) Coles 2 15 1 5-5 -1-15 WOW Supers store refurbs (#) no. refurbs completed Shortfall 7 8 9 1 11 12 13 14 15 16E Target no. refurbs completed 15 1 5-5 -1 Coles store refurbs (#) no. refurbs completed Target no. refurbs completed Shortfall 7 8 9 1 11 12 13 14 15 16E Taylor Collison Limited 26 July 216
Woolworths Limited Page 6 of 1 Ideal steps 4. Cultural change new CEO to set an inspiring long-term vision and reshape the culture to build employee morale. Some progress: Chairman espousing a listening culture and appointed internal CEO. Banducci had previously acknowledged the destabilising effect of high staff turnover, but now this decision to make a further 5 redundancies will cause additional damage to team morale. 5. Refocus attention on the consumer regain confidence in decision making, with reduced involvement of external agencies. Some progress: guided by Voice of the Consumer surveys. 6. Capital management Exercise better discipline in capital management, with increased spending in some areas, and less in others, through the lens of incremental return on invested capital. Good indication: Masters to go, with focus directed to Australian Supermarkets and maintenance capex. Wish to retain credit rating, but no intention to raise equity, which could have usefully provided flexibility. 7. Develop a clear pricing strategy a more aggressive stance that regains price leadership. Some further progress, in May committed to spending an additional $15M on price, service and loyalty in 2H16, over and above the level set just over two months earlier. With competitors likely to react accordingly, we suspect this won't be end of the "investment" treadmill. 8. Revised range refine the merchandise range, featuring a revamp of own brand. Limited progress, with the Essentials brand gradually replacing Homebrand, and Woolworths to replace Select. Rather than cosmetic changes, we would prefer if own brand had the quality of branded, but at ALDI prices. 9. Reduced emphasis on cost cutting having already cut head count per store, the group is already rather lean, and could actually do with greater investment in labour and inventory, not less. Limited progress: some return of store hours, but likely inadequate given head count per Woolworths Supermarkets store has fallen 25% over 7 years, from 156 in FY8 to 116 in FY15 (Figure 3). 1. Improve supplier relationships adopt a more collaborative approach, although this will involve Woolworths absorbing cost increases, crimping profits. Some progress: little more willing to accept cost increases, address suppliers, and adhere to the Code of Conduct. 11. Improve marketing and loyalty programme improvements are necessary, but alone can t fix all its problems. Little progress: removed Cheap Cheap, but subsequent messaging varied. Reappointed a former advertising agency. Everyday Rewards programme dumped, but replacement not well received, with more changes needed. The number of products eligible for Woolworths Rewards has seldom surpassed management s stated target of 5 items (or ~2% of the entire range) (Figure 4). 12. Open, honest and transparent be more, not less, forthright with investors. Little overall change: pleasingly, Voice of Consumer figures for some metrics are now being shared, and plans to disclose Liquor separately; but no improvement in other areas, such as Woolworths claiming they are cheaper than Coles, but not quantifying this, and no reference to the effect of 1% discount vouchers. Figure 3. Head count in total and per store: (a) Entire group, and (b) Australian Supermarkets only 2 175 15 125 1 Group head count (#'k) 75 5 25 Head count (LHS) Heads per store (RHS) Group heads per store (#) 9 95 5 1 15 8 7 6 5 4 3 2 1 Supers head count (#'k) 125 1 75 5 25 Heads per store (RHS) Head count (LHS) Supers heads per store (#) 9 95 5 1 15 16 14 12 1 8 6 4 2 Taylor Collison Limited 26 July 216
Woolworths Limited Page 7 of 1 Figure 4. Number of products eligible for Woolworths Reward Dollars each week from Woolworths Supermarkets Eligible SKU count (#) 5 4 3 2 1 47 225 393 312 235 2 354 277 21 219 197 29 231 246 169 139 165 191 197 197 19 87 189 212 163 133 145 116 43 414 397 368 55 57 59 358 361 37 312 WOW target of 5 SKUs avg. is 268 28 4 11 18 25 2 Oct Nov Dec 9 16 23 3 6 13 2 27 3 1 17 24 2 Jan Feb Mar 9 16 23 3 6 13 2 27 4 11 18 25 1 8 15 22 29 6 13 2 Apr May June July Source Company (https://www.woolworths.com.au/shop/productgroup/dnd-woolworths-rewards), Taylor Collison Research We are not prepared to accept just rhetoric, but need tangible evidence of the aforementioned steps being clearly addressed. Only then will we draw comfort that a turnaround is achievable, if the 3-5 year timeframe could be shortened, and does the stock warrant greater investment consideration. As it stands today, Woolworths is still facing a long road ahead. We anticipate the recovery process will be a slow grind, which invariably will take longer than expected to win back customers, mute any potential competitive response in an increasingly hostile environment, and stabilise profitability. We view 217, not 216 as consensus would suggest, as the trough year for earnings from continuing operations (aside from Home Improvement). This will be associated with a cut to the dividend payout ratio from 7% to 5%. Valuation and recommendation We consider how the future could unfold for Woolworths by modelling three scenarios. The key assumptions vary by same store sales growth (Figure 5) and EBIT margin (Figure 6) of Australian Supermarkets, which ultimately affects group profitability (Figure 7). Profit margins in Australian Supermarkets are likely to fall from ~8.3% in FY15 to 4.85% in FY16, then reach 4.25% in FY17 before stabilising thereafter at 4.5% (base case was 5.%), worse case 4% (bear unchanged), or 5% (bull case was 6%). Following the FY16 operating model review, we have revised our earnings estimates (Table 1). The main difference relates to a decline in forecast base case EBIT margins for Australian Food Liquor & Petrol: from 4.86% to 4.66% in FY16; from 4.51% to 4.16% in FY17; from 4.66% to 4.28% for FY18 onwards. Figure 5. Australian Supermarkets under three scenarios: (a) Same store sales growth; and (b) Sales revenue AU Supers SSS growth (%) 1% 8% 6% 4% 2% % -2% -4% 5 1 15 2E Bull 4.% Base 2.5% Bear 1.% AU Supers Sales ($BN) 45 4 35 3 25 2 15 1 5 5 1 15 2E Bull 41.9 Base 39.5 Bear 37.2 Taylor Collison Limited 26 July 216
Woolworths Limited Page 8 of 1 Figure 6. Australian Supermarkets under three scenarios: (a) EBIT margin; and (b) EBIT dollars AU Supers EBIT margin (%) 9% 8% 7% 6% 5% 4% 3% 2% 1% % 5 1 15 2E Bull 5.% Base 4.5% Bear 4.% Supers EBIT ($BN) 3.5 3. 2.5 2. 1.5 1..5. 5 1 15 2E Bull 2.1 Base 1.8 Bear 1.5 Figure 7. Woolworths Limited profit under three scenarios: (a) EBIT; and (b) Net profit after minorities Group EBIT ($BN) 4.5 4. 3.5 3. 2.5 2. 1.5 1..5. 5 1 15 2E Bull 3.1 Base 2.8 Bear 2.5 Group NPAT ($BN) 3. 2.5 2. 1.5 1..5. 5 1 15 2E Bull 1.9 Base 1.7 Bear 1.5 Table 1. Revised base-case earnings estimates (Home Improvement shown as a continuing operation in FY16) P&L item ($M) New 216E Old 216E Chg. (%) New 217E Old 217E Chg. (%) New 218E Old 218E Chg. (%) Stores 3,977 3,978.% 4,1 4,34 -.8% 4,44 4,9-1.1% Sales 6,158 6,177.% 58,824 59,433-1.% 59,976 61,384-2.3% EBITDA 3,427 3,55-3.4% 3,42 3,775-9.9% 3,628 4,48-1.4% EBIT 2,331 2,454-5.% 2,414 2,634-8.4% 2,573 2,838-9.4% Normalised NPAT After MI 1,398 1,484-5.8% 1,442 1,598-9.7% 1,545 1,734-1.9% Reported NPAT After MI -1,322-471 -18.9% 1,442 1,598-9.7% 1,545 1,734-1.9% Normalised EPS (cps) 19.3 116. -5.8% 112.8 125. -9.7% 12.8 135.6-1.9% DPS (cps) 77. 81. -4.9% 56. 62. -9.7% 6. 68. -11.8% Source Taylor Collison Research DCF valuation A $17.25 per share expected value is derived using a DCF methodology, probability weighted for the three scenarios, varying from $12.97 to $22.7 per share (Table 2). Table 2. Probability weighted valuation using a discounted cash flow methodology Scenario DCF valuation Probability Product Bear $12.97 25% $3.24 Base $16.98 5% $8.49 Bull $22.7 25% $5.52 Probability weighted average $17.25 Current market price $24.3 Discount/(premium) to valuation -41% Source Taylor Collison Research Taylor Collison Limited 26 July 216
Woolworths Limited Page 9 of 1 SOTP valuation A $17.76 per share expected value is derived using a sum-of-the-parts methodology probability weighted for the three scenarios, varying from $13.86 to $21.89 per share (Tables 3-4). Table 3. Probability weighted valuation using a sum-of-the-parts methodology in FY17 Scenario SOTP valuation Probability Product Bear $13.86 25% $3.46 Base $17.65 5% $8.83 Bull $21.89 25% $5.47 Probability weighted average $17.76 Current market price $24.3 Discount/(premium) to valuation -37% Source Taylor Collison Research Table 4. Detailed sum-of-the-parts valuation in FY17 Division Bear EBIT Base EBIT Bull EBIT Bear Base Bull Bear Base Bull ($M) ($M) ($M) multiple multiple multiple valuation valuation valuation Australian Supermarkets 1,333 1,534 1,741 1 11 12 13,329 16,873 2,887 Liquor 372 372 372 12 13 14 4,464 4,836 5,28 Petrol 7 7 7 8 9 1 56 63 7 Aust. Food, Liquor & Petrol 1,775 1,976 2,183 1 11 12 18,353 22,339 26,794 New Zealand Supermarkets 292 292 292 1 11 12 2,924 3,216 3,58 General Merchandise 36 36 36 6 7 8 217 253 289 Hotels 233 233 233 1 11 12 2,326 2,559 2,792 Unallocated -123-123 -123 1 11 12-1,258-1,379-1,51 Total 2,213 2,414 2,62 1 11 12 22,562 26,988 31,883 Plus: Cash 1,2 1,2 1,2 Plus: Mkt Value of LEP & GRB 64 72 8 Plus: Home Timber & Hardware 25 25 25 8 9 1 2 225 25 Enterprise Value 23,828 28,287 33,215 Less: Gross Debt 4,525 4,525 4,525 Less: Minority Interest in Hotels 582 64 698 Less: Lowe's Put Option 1, 55 Equity Value 17,722 22,572 27,992 Shares on Issue 1,279 1,279 1,279 Equity Value Per Share 13.86 17.65 21.89 Discount/(Premium) to valuation -75% -38% -11% Source Taylor Collison Research Blended valuation and recommendation Our preferred approach is an equal blend of both DCF and SOTP methodologies, probability weighted for the various scenarios. This generates a blended valuation of $17.51 per share (rounded to $17.5 was $19.3), derived from bear $13.42, base $17.31, and bull $21.98. With the current market price of $24.3 exceeding our valuation by 39%, Woolworths remains overpriced. Consequently, our recommendation remains Underperform. All other things being equal, the stock price would need to fall below $17.5 per share before we would be inclined to upgrade this recommendation. Conclusion We continue to recommend investors steer clear of Woolworths after the results of this operating model review. Despite the announced changes, Woolworths faces a long road ahead. For the most part, management is only beginning to grasp the scale of their problems, how far they will have to go to lure back customers, or how bad it could actually get. Preparedness is required for more far-reaching changes. Among other things, the company requires: (i) A distinct point of difference; (ii) A clear 5 year plan; and (iii) Better execution. With the shape and time required for a sustained recovery remaining underestimated by the stock market, investors should avoid the stock. A stock price below $17.5 per share, all other things being equal, is needed to compensate for the risk involved. Taylor Collison Limited 26 July 216
Woolworths Limited Page 1 of 1 Disclaimer The following Warning, Disclaimer and Disclosure relate to all material presented in this document and should be read before making any investment decision. Warning (General Advice Only): Past performance is not a reliable indicator of future performance. This report is a private communication to clients and intending clients and is not intended for public circulation or publication or for the use of any third party, without the approval of Taylor Collison Limited ABN 53 8 172 45 ("Taylor Collison"), an Australian Financial Services Licensee and Participant of the ASX Group. TC Corporate Pty Ltd ABN 31 75 963 352 ( TC Corporate ) is a wholly owned subsidiary of Taylor Collison Limited. While the report is based on information from sources that Taylor Collison considers reliable, its accuracy and completeness cannot be guaranteed. This report does not take into account specific investment needs or other considerations, which may be pertinent to individual investors, and for this reason clients should contact Taylor Collison to discuss their individual needs before acting on this report. Those acting upon such information and recommendations without contacting one of our advisors do so entirely at their own risk. This report may contain forward-looking statements". The words "expect", "should", "could", "may", "predict", "plan" and other similar expressions are intended to identify forward-looking statements. Indications of and guidance on, future earnings and financial position and performance are also forward looking statements. Forward-looking statements, opinions and estimates provided in this report are based on assumptions and contingencies which are subject to change without notice, as are statements about market and industry trends, which are based on interpretations of current market conditions. Any opinions, conclusions, forecasts or recommendations are reasonably held at the time of compilation but are subject to change without notice and Taylor Collison assumes no obligation to update this document after it has been issued. Except for any liability which by law cannot be excluded, Taylor Collison, its directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying upon the information. Disclosure: Analyst remuneration is not linked to the rating outcome. Taylor Collison may solicit business from any company mentioned in this report. For the securities discussed in this report, Taylor Collison may make a market and may sell or buy on a principal basis. Taylor Collison, or any individuals preparing this report, may at any time have a position in any securities or options of any of the issuers in this report and holdings may change during the life of this document. Analyst Interests: The Analyst(s) may hold the product(s) referred to in this document, but Taylor Collison Limited considers such holdings not to be sufficiently material to compromise the rating or advice. Analyst(s) holdings may change during the life of this document. Analyst Certification: The Analyst(s) certify that the views expressed in this document accurately reflect their personal, professional opinion about the financial product(s) to which this document refers. Date Prepared: 26 July 216 Analyst: Mark Wade Release Authorised by: David Cutten Taylor Collison Limited 26 July 216