Inflation, underlying cost growth and COVID-19 related costs all combined to create the strange illusion of rising sales but falling earnings in the first half year for Woolworths Group.
WOW reported sales growth of 8% in 1H22 but EBIT fell 11%. By what sorcery could this strange outcome have occurred?
Firstly, the company operated under very difficult conditions throughout the period. Trading conditions of all manner and guise were imposed including RAT testing in DCs, isolation requirements on team members, double-dose vaccine mandates in Victoria, and lockdowns in western Sydney among others.
Underlying cost growth was also on the rise which we attribute to online sales.
Food inflation had accelerated 2-3% in early 2022, according to the company, which is a positive sign for sales and earnings. The higher rate of inflation is showing through in packaged goods, while fresh produce and tobacco are still declining.
Comparable sales growth over the last two years at WOW has been impressive. Perversely, lockdowns boosted sales as people ate at home more and stocked pantries. As the economy re-opens, volumes will slide a little but will be complemented by higher prices.
The past three years has seen higher operating cost growth, some of which can be sheeted home to COVID disruptions which were $239 million in 1H22 ($277 million in 1H21). Aside from this, operating costs have still been going up and this is probably due to higher online sales.
The media is often infatuated with the quarterly competition on sales growth between WOW and COL and on this measure, WOW has looked superior recently. WOW generated compound annual sales growth of 7% between 1H20 and 1H22 compared to COL at 4.3%. But that only tells half the story. Examining the cost growth over the same period reveals WOW’s growth is much higher than COL.
Consequently, WOW’s earnings growth (2.2%) has been inferior to COL (6.6%) over that period.
One reason for this oddity may be the profitability of online sales. Most online shoppers at WOW are simply switching channels, i.e. shopping online instead of in-store. The economics of online shoppers for WOW is actually quite poor given the low charge for delivery and in-store pickers. The online channel, including click and collect, barely washes its face in EBIT terms but competition prevents WOW from increasing its charges.
Sales and EBIT at BIG W were materially impacted by store closures in the period, but this should now reverse.
The New Zealand supermarket business experienced similar conditions and outcomes as in Australia, although sales increased 8.3% (in NZD) compared to EBIT growth of 3.3%.
Investment view
Given the elevated costs over the last two years, we think WOW will try to proactively lower its costs over the next two years.
WOW said Australian Food sales in the first 7 weeks of 2022 had increased about 5%, despite the Omicron interjection.
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. Our sector preference is MTS.
