Discuss about the Relevant Quantitative and Quantitative Factors.
The evaluation of stock for investment purpose needs to be performed by considering the relevant quantitative and quantitative factors. The quantitative analysis for a stock tends to consider the financial statements using tools such as ratio analysis and trend analysis. The qualitative factors tend to instead focus on the innate lucrativeness of the business model in terms of not only profitability but also scalability along with the market share and brand value. Further, the above information needs to be analysed keeping into mind the corresponding performance of the peer group. This report aims to review the relevant qualitative and quantitative parameters concerned with Woolworths performance in the last five years so as to recommend whether an investor should invest in the stock or not. Besides, the report also computes the valuation of the Woolworths stock using the given information to conclude if the stock is overpriced or underpriced.
Company Overview
The organised retail segment in Australia is dominated by Woolworths which along with Coles has converted the supermarket industry into a virtual duopoly as is evident from the figure listed below.
The Woolworths group is a diversified group with interests across multiple businesses such as hotels, fuels, home improvement even though majority of the revenue is contributed by the supermarkets business. Over the years, the company has grown through the acquisition route that has expanded the business of the company into niche segments and given rise to a conglomerate. The group is based in Australia with a presence of about 950 stores spread all over. Besides Australia, the group has sizable market share in the organised retail market in New Zealand. Moreover, the company has small presence in various international markets such as Hong Kong, UK, South Africa and India (Woolworths, 2013). With the coming ot various discount retailers particular Aldi, the market share of the company has fallen and may decline further in the times ahead. This decline may be worsened by the persistent weakness in the trading environment where the discount retailers may be favoured by the customer (Mitchell, 2015).
The performance of the Woolworth’s stock price over the last one year is captured in the graph below (Yahoo Finance, 2016).
It is clear from the graph on display above that the stock price has undergo a significant decline of about 25% in the period under consideration. It is apparent that the stock has performed worse than the broad market index. However, the trading environment in Australia continues to be weak which is a worrisome sign for the stock. Also, competition from German discount retailers is an issue for the company which may keep the price subdued in the near future despite correction. Hence, unless the market fundamentals undergo significant improvement, a sustained upside on the stock may not materialise.
As highlighted above, the quantitative analysis of Woolworths would include take into consideration the financial statements from FY2011 to FY2015 and for the given period perform the following.
The analysis of the various key trends based on the horizontal analysis shown in the Appendix 1 is given below.
Revenue – The revenue of the group has registered a steady rise from FY2011 onwards till FY2014. However, the trend is reversed in FY2015 as there has been slight decline in total revenue. This is caused by the drop in fuel sales which have seen a drop in both prices and associated volumes. The sales in volume terms were lesser owing to “Caltex Alliance” arrangement alliance which was put in place in Q2, 2015. However, if the sales from fuel are excluded, then the sales even in FY2015 have registered a slight increase of 2.5% despite the competition from discount retailers and unfavourable market conditions (Woolworths, 2015).
Gross Profits – The company’s gross profits have enhanced over the years primarily due to the steady increase in the revenues along with the improvement in the profit margins at the gross level achieved through improvement in processes and savings in purchases.
Net profit – During the year FY2012, there was a decline in the net profit caused due to discontinued operations which attracted a loss to the tune of $ 366 million (Woolworths, 2012). However, during the next two years the net profits rose on account of better operating margins caused due to lower operational costs along with keeping the employee costs under check. However, the net profits in FY2015 have suffered a decline caused due to a hike in the operating expenses caused due to higher superannuation costs related with employees along with increased wage bill (Woolworths, 2015).
Interest Expenses – The company’s interest expenses displayed an upward trend but these reached their peak level in FY2013. After FY2013, there has been a sizable decrease in the interest costs caused due to the decline in the overall debt level particularly long term (Woolworths, 2015).
Short term debt and long term debt – From the relevant data on the debt levels, it is clear that the company intends to lower the long term loans and enhance the short term debt if required. The decrease in long term borrowing is indicative of falling investment by the company for setting up new stores in Australia and elsewhere. Further, the short term borrowing is on the rise due to the higher working capital needs for the company (Woolworths, 2015).
Inventory – There has been a slight decrease in the inventory levels at the end of FY2012 but ever since the inventory level is on the rise which is not a positive sign for the company as it indicates that the demand for the company’s products is weak. This is an ongoing issue for the business as has also been pointed by the Chairman in the annual report.
Shareholder’s equity – The shareholder’s equity has shown a steady rise in the period under consideration which has been brought about by the rise in the retained profits on account of the net profits made in each financial year. Another additional factor contributing to this trend is the rise in paid capital of the group.
The analysis of the various key trends based on the horizontal analysis shown in the Appendix 1 is given below.
Gross profit margins – The company’s profitability margins on gross level have shown steady improvement over the period under consideration. This is apparent from the fact that even in FY2015, despite the falling profits margins in fuel and weak macroeconomic climate, the company was successful in improving the margins by 12 bps (Woolworths, 2015).
Operating expenses – The operating expenses expressed as revenue percentage is on the rise and the situation has worsened tremendously in FY2015 when there has been substantial increase in the operating expenses which has led to a dip in the net profit margins to the tune of 91 bps. Clearly, there is a need to atleast stem this trend in the near future and reverse this in the medium term as trading environment improves (Woolworths, 2015).
Receivables – The receivables as a percentage of total assets has witnessed a declining trend. This trend was not obeyed only in FY2013 when this percentage actually witnessed an increase. The decreasing contribution of the receivables is a positive signal for the company and augers well for reducing the overall cash cycle since it ensures that the company is able to generate cash from the sales on a regular basis without unnecessary details that can prove to be disruptive for the company’s short term liquidity (Woolworths, 2011; 2012; 2013; 2014; 2015).
Current liabilities – The current liabilities expressed as a percentage of the total liabilities and shareholder’s equity has witnessed a declining trend. This may be attributed to the continuous increase in the overall equity due to retained profits and fresh equity capital which has exceeded the percentage growth in the current liabilities (Woolworths, 2011; 2012; 2013; 2014; 2015).
The significant ratios considered for the analysis of Woolworths have been summarised in the Appendix 2. The implications of these with regards to the company’s performance are stated below.
During the period from FY2011 to FY2014, the current ratio experienced improvement while it witnessed a decline in FY2015. This decrease can be explained due to rise in the short term debt by around $ 1.4 billion at the FY2015 end compared to the corresponding year end in FY2014 (Woolworths, 2015). The current ratio is significant and is indicative of the short term liquidity which is pivotal in case of organised retail. A concerning trend for the company is that inventory contributes almost 60% of the total current assets and hence liquid assets such as cash comprise a small portion of current assets. Hence, it is likely that in the near term, a short term liquidity crisis may develop if the business climate does not show any improvement (Brealey, Myers & Allen, 2008). The company’s major competitor i.e. Wesfarmers boasts of a higher current ratio which lies in the vicinity of 1.1 to 1.5. As a result, it is apparent that the company requires improvement in this respect (Morningstar, 2015).
The trend with regards to P/E ratio has been mixed since there was an increase during the period FY2011 to FY2013 but the trend reversed for the period FY2014 to FY2015. The rise in P/E ratio at the end of FY2012 was caused mainly due to EPS decline caused by heavy losses on the back of discontinued operations (Woolworths, 2012). There was an improvement in the P/E ratio in the subsequent year due to outperformance by the company which was extended to the next year i.e. FY2014. However, in the next year i.e. FY2015, the performance dipped significantly which is reflected in the form of reduced EPS and hence led to a decline in the P/E ratio. The P/E ratio for the industry is pegged at 21 and hence it is evident that the company is given lower valuations which may be explained due to the diversified nature of the business which is held as a single company. However, this explanation may not be accurate since Wesfarmers has a higher P/E as compared to Woolworths even though it is more diversified than Woolworths. This indicates underperformance by the Woolworths stock during the preceding two years (Morningstar, 2015).
There is no uniform trend with regards to the ratio indicating the net profit margin. The net profit margin witnessed a decline during FY2012 caused due to discontinued operations and the resulting loss of $ 366 million. However, the performance with regard to net profits improved during both FY2013 and FY2014 due to better than expected gross margins even though the operational expenses continued to remain constant. The net profit margins have dropped by almost 50 bps during FY2015. This may be explained on the back of higher operational expenses particularly related to employee salaries and associated benefits (Woolworths, 2015). The drop in margins for fuel also had an adverse effect on profitability during FY2015. However, the net profit ratio for the company is in accordance with the industry standards which is estimated around 3.75%-4.25% (Morningstar, 2015).
Besides two years namely FY2012 and FY2015, the ROA has continued to remain constant during the period under consideration. The FY2012 decline in ROA was not disconcerting from the investor perspective as it was driven by loss arising from discontinued operations. But the same cannot be concluded for the dip in ROA in FY2015 which is driven by a decline in the net income to the tune of $ 300 million (Woolworths, 2015). Additionally, continued competition from discount retailers and weak demand would continue to exert downward pressure on ROA which is not favourable from the investor perspective (Brealey, Myers & Allen, 2008).
The contribution of debt to the total assets has continued from FY2011 till FY2014 which is favourable for the company. But this trend has reversed in FY2015 due to the rise in short term borrowing to the tune of $ 1.4 billion (Woolworths, 2015). This surge in current borrowing can be attributed to weak trading environment where the demand is weak and hence the working capital requirement is larger. Even though there has been a decline in the debt ratio, but still there are no long term liquidity issues that the company faces (Brealey, Myers & Allen, 2008).
Based on the computed values, it is apparent that the interest coverage had improved in FY2012 as compared to the previous year before deteriorating in FY2013 primarily on account of the surge in interest expenses. However, post FY2013, there is a decline in the overall debt level which is reflected in the form of lower interest cost. This is responsible for the improvement in the interest coverage in FY2014 but the ratio has declined in FY2015 due to dip in the EBIT (Woolworths, 2015). Despite this, the interest coverage continues to stay healthy and hence the company does not face much risk of default on interest payment in the near future (Brealey, Myers & Allen, 2008).
The review of the quantitative and qualitative parameters carried out above indicates that it is not prudent to invest in the Woolworths stock at the present time. This is despite the fact that the stock has corrected by about 25% over the last year and may seek a value buy. However, the chances of a recovery in the stock seem slim till the time there is definite improvement in the trading environment which does not look certain in the present. However, one of the limitations of the previous analysis is that it is based on historical performance and hence the future performance may be significantly different from the past performance. But currently, it seems highly unlikely.
The Gordon dividend model is deployed for ascertaining the intrinsic price of the Woolworth’s stock (Damodaran, 2008).
Woolworths fair price = Next year dividend/ (Return required – Constant growth of dividends)
Return required on the stock = 9% pa
Constant growth rate of dividend = 4% pa
Dividend paid by Woolworth per share in 2015 = 1.0286 + 0.957 = $ 1.9856
Expected dividend per share in 2016 = 1.9856 * 1.04 =
Hence, dividends paid next year = 1.9856 * 1.05 = $ 2.065
Woolworth stock price = 2.065/(0.09-0.04) = $ 41.3
Since the Woolworth stock is currently trading at $ 21.7, hence it is evident that the stock currently is highly underpriced. The aberration in valuation can be explained on the basis of the expectations with regards to dividend growth from the investor perspective which may be considerably lower than 4% considering the lacklustre performance in FY2015. Further, it is also possible that the stock is oversold due to negative sentiments associated with the retail sector at the present.
References
Brealey, R, Myers, S & Allen, F 2008, Principles of Corporate Finance, 9th edn, McGraw Hill Publications, New YorkDamodaran, A 2008, Corporate Finance, 3rd edn, Wiley Publications, LondonMitchell, S 2015, Coles, Woolworths, IGA to lose market share to Aldi, David Jones, says Moody’s, The Sydney Morning Herald, Available online from https://www.smh.com.au/business/retail/coles-woolworths-iga-to-lose-market-share-to-aldi-david-jones-says-moodys-20150813-giy6x0.html (Accessed on July 14, 2016)Morningstar 2015, Woolworths Ltd, Morningstar Limited, Available online from https://financials.morningstar.com/valuation/price-ratio.html?t=WOLWF®ion=usa&culture=en-US (Accessed on July 14, 2016)
Woolworths 2011. Annual Report 2011, Woolworths Limited, Available online from https://www.woolworthslimited.com.au/icms_docs/129899_Annual_Report_2011.pdf (Accessed on July 14, 2016)
Woolworths 2012. Annual Report 2012, Woolworths Limited, Available online from https://www.woolworthslimited.com.au/annualreport/2012/ (Accessed on July 14, 2016)
Woolworths 2013. Annual Report 2013, Woolworths Limited, Available online from https://www.woolworthslimited.com.au/icms_docs/137198_Annual_Report_2013.pdf (Accessed on July 14, 2016)
Woolworths 2014. Annual Report 2014,Woolworths Limited, Available online from https://www.woolworthslimited.com.au/annualreport/2014/index.html (Accessed on July 14, 2016)
Woolworths 2015. Annual Report 2015, Woolworths Limited, Available online from https://www.woolworthslimited.com.au/icms_docs/182381_Annual_Report_2015.pdf (Accessed on July 14, 2016)
Yahoo Finance 2016, Woolworths Ltd (WOW.AX), Yahoo Finance, Available online from https://au.finance.yahoo.com/echarts?s=WOW.AX (Accessed on July 14, 2016)
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