In the immediate aftermath of the Great Financial Crisis many Australian investors basked in the glow of the relative immunity the resources boom provided for the Australian economy. Our banks were considered some of the best in the world; our real estate market was judged to be safe from the kind of collapse that occurred in the United States because of the way mortgage loans here are managed; housing prices were booming; the Chinese seemed bent on buying up every ounce of minerals we could produce; and our government assured us they had the cash on hand in the event the unthinkable happened. All was right with the world.
Today confidence in the future of the Australian economy has ebbed out like the tides and left us with some troubling, although not yet calamitous, trends. Chinese growth is slowing, Europe may be in a shambles, and Australian GDP came in under expectations as unemployment is rising and housing prices are falling.
In the face of all this, many Australian investors have chosen to avoid the share market. Others, however, are well aware of the ability of markets to rebound and are refusing to abandon ship. However, those who remain often switch their focus to more defensive shares. One of the first things newcomers to share market investing learn is that when times look like they might be getting tough, consumer staple stocks can offer some safety.
Simply put, no matter how bad things are, the consumer simply cannot survive without the basic staples of life like food and other household products. You can do without upgrading your television and other electronic gadgetry, but declining consumer confidence does change the way consumers shop for staples. They begin to look for sales and bargain buying with increased frequency. This puts margin pressure on even the best Food and Staples Retailers. And who are the best of breed in the Australian Food and Staples Retail Sector? Here are three companies any defensive investor might want to consider:
|Company/Code ||Mkt Cap ||Current Share Price ||52 Week High ||52 Week Low |
|Woolworths/WOW ||$31,396M ||$25.29 ||$27.99 ||$23.21 |
|Wesfarmers/WES ||$33,555M ||$29 ||$34.18 ||$26.04 |
|Metcash/MTS ||$3,170M ||$4.11 ||$4.37 ||$3.62 |
Woolworth’s is one of the most recognised brands in Australia and has dominated this space but with Wesfarmer’s acquisition of the Coles Group of grocery stores in 2008, the two giants have begun a battle for market dominance. Standing in the shadows lies Australia’s large group of independents in the IGA (Independent Grocers Association), supplied by wholesaler Metcash.
Although not exactly a household name in Australia, MTS (Metcash) controls 20% of the space. They operate with four business segments organised to meet their respective customer base – IGA Distribution, Australian Liquor Marketers, Campbells Wholesale, and Mitre 10 Hardware. These four channels consist of a variety of traditional retail grocery and independent hardware outlets, convenience stores, hotels, and cash and carry wharehouse outlets for groceries and liquor. In September 2011 the company acquired the Franklin Stores grocery chain and won approval over an Australian Competition and Consumer Commission (ACCC) ruling against the deal.
While WOW and MTS are close to being pure plays in the food and staples space, Wesfarmers is one of Australia’s largest conglomerates. Their successful turnaround of the Coles chain has put them front and center against Woolworths, but they also have numerous other business segments both within and outside of the retail sector. They have operations in coal mining, energy, chemicals and fertilisers, industrial and safety products, office supplies, and insurance.
Note that despite the extreme volatility in share price movement during 2011, the share prices of these three companies were relatively stable. WOW’s current share price is less than 10% below its 52 Week High; MTS is now trading less than 5% below its high; and WES is down from its high approximately 12%. The following table combines some market valuation ratios with a few key performance indicators for the three shares:
| ||P/E ||P/EG ||ROE ||Div Yld ||Operating Margin||Net Profit Margin|
|WOW ||14.56 ||2.05 ||4.8% ||27.5% ||7.5% ||3.8% |
|WES ||15.21 ||.91 ||5.5% ||7.6% ||7.3% ||3.5% |
|MTS ||12.07 ||2.05 ||6.7% ||18.1% ||3.9% ||2.0% |
|Sector ||14.88 ||2.05 ||-- ||5.5% ||-- ||-- |
Although the variation between the Price Earnings Ratios of these companies is slight, on a valuation basis MTS appears cheapest when compared to the Food and Staples Retailing Sector and WES is the most expensive. However, with a P/EG under 1.0, WES appears to have the edge in expected future growth. All pay a respectable dividend and both WOW and MTS exceed the 15% minimum ROE threshold set by both Value and Growth at a Reasonable Price (GARP) Investors. WOW and WES have a clear edge on the all important retail measure of margins. Economies of scale dictate these larger companies are in a better position to absorb the pricing discounts needed to thrive in a market brimming with declining consumer confidence.
Here is an overview of how the analyst community currently views these shares. WOW is a clear favorite with BUY ratings from Citi, JP Morgan, UBS, Deutsche Bank, and RBS Australia. Macquarie rates WOW as NEUTRAL and BA-Merrill Lynch and Credit Suisse see the company as UNDERPERFORM. The Citi rating is an upgrade from NEUTRAL on 14 March, 2012. The analyst is of the opinion that Woolworth’s scale gives them a competitive edge over the Wesfarmer owned Coles chain. RBS Australia was favorably impressed with recently reported margin growth at Woolworths.
Only two analysts rate WES a BUY – JP Morgan and BA-Merrill Lynch. Both think the turnaround performance at Coles has more upside potential. Citi, Deutsche Bank, Macquarie, UBS, and Credit Suisse all have NEUTRAL ratings; with most of the contrary opinion that the growth story at Coles may be over. RBS Australia has a SELL rating on the stock, citing major concerns over the company’s expansion plans in their coal business. The analyst at Macquarie also expressed concern Wesfarmers may be getting too big to effectively manage, which is a potential risk with any conglomerate that operates in unrelated businesses.
Credit Suisse and Citi have BUY ratings on MTS, with both citing the recent acquisition of the Franklin chain as offering significant upside potential going forward. The Credit Suisse rating was an upgrade on 01 December, 2011. UBS, Deutsche Bank, RBS Australia, Macquarie, and JP Morgan have HOLD or NEUTRAL ratings, with the Morgan rating a recent upgrade from Underweight. BA-Merrill Lynch is the only analyst on the negative end, with an UNDERPERFORM rating. Regardless of their rating, all these analysts cited the difficulty of pricing pressure on MTS from the major chains. However, Metcash’s above average dividend is a positive for investors.
Even the most defensive of investors should be concerned about growth potential. Without earnings growth, those attractive dividends can be cut or even eliminated temporarily. Conventional wisdom says a solid record of historical performance is a good indicator of future performance. This is especially true today as 5 year performance numbers reflect the impact of the GFC on a company’s business. The following table shows both 5 and 10 year growth rates for earnings and dividends, as well as 2 year forecasts:
| ||5 Year/10 Year Earnings Growth ||2 Year Earnings Forecasted Growth ||5 Year/10 Year Dividend Growth ||Forecasted Dividend Growth |
|WOW ||18.7%/14.9% ||7.1% ||15.6%/15.6% ||5.6% |
|WES ||-5.1%/5% ||16.8% ||-5.5%/4.3% ||12.6% |
|MTS ||8.1%/15.4% ||5.9% ||18.6%/20.6% ||4.2% |
As always, numbers need to be interpreted in an historical context, and the growth rates for WES demonstrate this dramatically. Their five and ten year growth lags far behind the impressive performance of WOW and the slightly less impressive numbers for MTS. However, WES did not acquire Coles until 2008. What’s more, their superior growth forecasts may be revised downward given the very recent news of a slowing economy in both Australia and China. The risk here is that if the upside with the Coles acquisition is truly already priced into the shares, the other business operations of Wesfarmers are highly influenced by deteriorating global economic conditions.
Note that both WOW and MTS grew dividends despite the GFC. Finally, fundamental performance indicators are the “mothers’ milk” of value investors, but when all is said and done the only number that really matters is share price. Even the most hard core value investor buys with the expectation that at some point market participants will recognise the true value of a company and its share price will then begin to reflect that value. So let us take a look at some ten year price charts for these companies. First we will compare the giants in this space – WOW and WES:
Over the full period Woolworths clearly outperformed Wesfarmers. At the time of the Coles acquisition in 2008 that company was far from healthy and there were serious questions about the ability of a conglomerate like Wesfarmers to turn Coles around. But they did and shareholders were rewarded for their efforts. By 2010 the share price of these two players was following roughly the same pattern.
How does tiny MTS fare in comparison with each of the “eight hundred pound gorillas” in the Food and Staples Retailing Sector? First, let’s look at Woolworths and MTS, followed by Wesfarmers compared to MTS:
Despite its small size, the share price performance of MTS compares very favorably to that of WES and slightly less so with WOW. Considering the share price performance and the fundamental indicators of the three companies, WOW appears to be the safest choice, warranting further research. You cannot overestimate the value of brand recognition and Woolworths has that in abundance. Wesfarmers offers diversification with its other businesses but that diversification comes with a certain amount of risk should global economies deteriorate further. MTS could do well with the Franklin chain, but investors there would do well to monitor their debt situation due to the cost of the acquisition.
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