Inflation is working positively for Woolworths as volumes remain steady. COVID costs are gradually receding, but supply chain issues are still a hindrance. The company is in good shape but is expensive.
Figure 1 shows the components of WOW’s comparable store sales growth since 1Q20. The chart shows inflation accelerated from -0.6% in 2Q22 to 2.7% in 3Q22 representing a +3.3pp rise in inflation. Volumes over that period slowed from 2.5% in 2Q22 to 1.7% in 3Q22. This shows that the trade off between inflation and volume is a net positive for WOW’s sales.
Inflation is clearly not going away anytime soon and will be the dominant factor in supermarket sales growth in the near term at least. Packaged grocery prices will likely increase throughout the rest of 2022 due to higher raw material prices affecting the cost of packaging. Some commodities, such as wheat, have been affected by the Russian invasion of Ukraine and will also make an impact.
Coles reported 3Q22 inflation of 3.3%, higher than WOW, over the same time frame, but there are differences in the way each company calculates inflation. If, instead, we look at the change in inflation between quarters, the increase at Coles was 3.5pp compared to WOW at 3.3pp.
BIG W reported comparable sales growth of -3.4% for 3Q22. Over a longer stretch of time, we see compound total annual sales growth of 7.7% over the last three years compared to industry growth of 4.0% pa. It is notable, however, that all department store operators have closed many stores over that period contributing to lower industry growth.
COVID costs have been a relevant factor since the pandemic forced everyone into masks and dollops of hand cleanser. The extra costs related to cleaning and PPE, security, extra staff as well as supply chain costs. In 3Q22, WOW reported COVID costs of $66 million and it appears the worst may be over for this factor. At 0.9% of sales in the quarter, this is well down from the peak of 2.1% back in 3Q20. WOW noted that about half of the quarterly costs related to New Zealand which is still timidly edging away from COVID restrictions. Across the whole company, we estimate WOW will have spent about $335 million on COVID costs in FY22f.
WOW provided guidance on its New Zealand business that has been hit hard by COVID impacts. The company now expects EBIT of NZ$120-140 million in 2H22f, down from NZ$167 million in 2H21. The difference is virtually all due to COVID costs. Sales are growing steadily in New Zealand (inflation) but WOW has lost some market share to rival Foodstuffs.
Investment view
On the subject of rising inflation, WOW CEO Brad Banducci said: “We have not yet seen a notable change in customer shopping behaviour.” As the pace of inflation has picked up this year, WOW has not lost any significant volume and sales growth has been good.
COVID costs remain a drag on earnings but will gradually dissipate. The issue is now more a problem in New Zealand but should eventually subside there too.
The last two years have been extraordinary for supermarket operators, but we think earnings can recover in FY23f.
However, we do not think the share price should be valued at almost 27x FY23f eps as consensus forecasts imply. A more sensible metric would be 25x, in our view. While we retain a Hold recommendation on the stock, we see better value in Metcash.
Risks to investment view
Competition could increase and negatively impact WOW’s profit margins. Inflation may be less than predicted, or raw material price increases might not be sustained.
Recommendation
We have retained our Hold recommendation.
