Income Report / Income Report: A deeper dive into the Woolworths Buy Back (WOW)

By Market Matters 03 April 19

Income Report: A deeper dive into the Woolworths Buy Back (WOW)

Market Matters Income Report 3rd April 2019

Local stocks are trading near the session highs as we approach midday, with the ASX 200 at 6277, its highest level since September 2018. The purse strings were loosened in Canberra overnight as the Government announced a budget fit for an election.

This morning we’ve seen retail sales out which was stronger than expectations – seems people are spending just not on houses - while the trade balance was also better than envisaged. Material stocks are leading the market, up +1.17% while the energy sector is lagging.

ASX 200 Chart

The past week saw the Income Portfolio up by +0.58%, helped by a +3% move in our recent BOQ purchase, while the recent Macquarie Hybrid (MQGPD) had a strong start to listed life, now trading at $102.54. MXT and NBI went ex-distributions. The ASX 200 Accumulation added +1.84%. In the current financial year, the portfolio is up +4.23% vs the benchmark (RBA + 4%) which is tracking at +4.13%, while the accumulation index has managed just +4.34% in the period. Since inception (5/7/2017) the portfolio is up +11.11%, outperforming its benchmark (RBA Cash plus 4%) at +9.57%.

A deeper dive into the Woolworths Buy Back

Woolworths is a popular income stock  even though it’s expected to yield just 3.19% in FY19 and trades on a relatively expensive est. P/E of 25x. Investors generally pay a high multiple for either growth in earnings, predictability / visibility on earnings or a combination of both. In the case of Woolies, earnings are forecast to grow at a steady 6% for the next 3 years which shows some growth and of course they sell mostly staples, things that we need to buy each week so the predictability of earnings is high. Factoring in the implied 6% growth it means WOW trades on around 23x  2021 earnings.

To put those P/E multiples into perspective, over the past 5 years WOW has traded on an average P/E of 18.1x and at no time during that period has WOW been more expensive than it is today. The obvious question being, is this P/E premium  justified?

On Monday they issued a market update and within it there were two bits of positive news, and the share price rallied more than 2% on the day.

1.    They announced the closure of ~30 BIG W stores out of their 183 strong network along with two distribution centres. The reason being that BIG W’s turnaround is taking longer than expected with WOW expecting an EBIT loss of $80-$100m in FY 19 which is above market expectations and only down marginally from the $110m loss in FY18. The costs to exit these stores will be about $370m. While the underlying reasons for the closures are not positive - the decisive action is, while it also reduces the likely losses in outer years which prompts earnings upgrades.

2.    They announced a $1.7 billion off-market buy-back

In terms of the buy-back, Shareholders who own Woolies shares, or buy them before the close of trade tomorrow (Thursday 4th April) can participate, and the buy-back closes after the 45 day rule allowing for the benefits of franking to be accrued. Just to recap that rule, a SMSF must hold company shares for at least 45 days (plus the day of purchase and day of disposal) to be entitled to franking credits, however this rule does not apply to individuals where the total franking credit entitlements for that financial year are below $5,000.*As always, consult with your accountant*

Shareholders have the option to tender stock into the deal at between a 10-14% discount to the market price – the deal will most likely be priced at a 14% discount comprising a $4.79 capital component and the rest paid out as a fully franked dividend.

If we assume a 14% discount is applied to yesterdays close of $30.85, the buy-back would be priced at $26.53 consisting of a $4.79 capital component and a $21.74 fully franked dividend. A $21.74 fully franked dividend is worth $31.05 in a zero tax environment plus the $4.79 capital component, or a total value of  $35.85 – which equates to a $5 / 16.2% uplift. The impact on other tax rates are shown below.

Source: Market Matters

WOW trades ex-entitlement on Friday, meaning that shares need to be bought by Thursday. The offer period opens on the 16th April and closes on the 24th May, all tenders need to be submitted by 7pm on the 24th May before the buy-back price and scale-back are completed on the 27th May. Proceeds would be paid on the 30th May.

In short, the offer looks good for those holders in a zero tax environment, or those with large capital gains imbedded in current holdings, however as we don’t own the stock, it comes down to whether or not it’s worth buying now to take advantage of the deal?

In reality, there is likely to be a large scale back applied to tendered shares meaning that we have to be comfortable holding Woolies from here – and we’re not.

While the action taken on Big W is a positive, and the buy-back is good for some, this doesn’t change the fact that sales are struggling, not just in WOW but also for Coles. The 1H results for Woolies showed they are going backwards in nearly every division, while both Woolies and Coles are experiencing higher costs in an environment of falling prices. WOW now trading on a very ritzy PE premium to the market of >45% leaving very little room for error.

Both Supermarket operators (WOW/COL) have now made it crystal clear themselves via bearish commentary that things are getting tougher with consumer sentiment and the retail landscape facing a number of headwinds. At MM we don’t  expect a lagging Coles to sit back, nor Aldi and IGA for that matter. Worth also considering that Australia is the second most concentrated grocery market in the world behind NZ and competition is likely to become more aggressive with all players investing further, especially Coles, and ALDI, Costco, IGA, AMZN, Kaufland and potentially Lidl.

On such a high multiple and with mid-single digit growth and rising competition, we are fundamentally negative on Woolworths.

Technically, WOW could squeeze up to ~$31.50 however MM would be sellers

Woolworths (WOW) Chart

Conclusion (s)

The WOW off market buy-back looks an attractive exit point from an expensive stock
We are not interested in WOW for income or growth on current valuations

Have a great day!

James & the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

Disclaimer

All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 3/04/2019

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