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Big W The Big Surprise At Woolworths

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Woolworths ((WOW)) has impressed brokers with its performance in the September quarter, being the fourth consecutive quarter in which it has outperformed its competitor Coles ((WES)). The main surprise on the positive side was Big W, where like-for-like sales rose 2.9% and halted four consecutive years of declines. Brokers observe few promises were made ahead of the key Christmas trading period although management appeared confident momentum would be maintained.

Ord Minnett considers the turnaround in the company's food business is well underway, confident the cultural change at Woolworths will mean this improvement is sustained. The recovery in like-for-like sales growth and operating earnings (EBIT) margins suggest 2016 was the low point for food margins. A sale of the petrol business to BP should help further reduce debt and raises the prospect for capital management in the medium term, the broker suggests.

Australian food like-for-like sales grew 4.9%. Deutsche Bank estimates this eased to 4% in the final six weeks of the quarter, consistent with the company's comments that deflation was most acute towards the end of the quarter. The broker notes modest upgrades to New Zealand and hotels were offset by some small downgrades elsewhere. Australian food business has been complicated by an accounting change around agency agreements and, in the wash up, Deutsche Bank's earnings estimates are unchanged, with a Buy rating maintained.

Total food sales growth decelerated to 4.7% from 7.8% in the prior quarter, with around 30 basis points explained by a change in the way the company accounts for newspapers/magazines and a move to an agency model. Store closures were also weighted towards the end of the June quarter and more small-format store openings cover the remaining difference, Morgan Stanley explains.

The comparable period was easy, so growth will become more difficult, the broker asserts and, while the company is better placed to tackle competitive threats, the shares reflect a long-term outlook that is too optimistic.

Macquarie is also cautious about the definition of the comparable sales statistic in Australian food, not having the benefit of the sales performance in terms of gross margins/operating earnings while the holiday period remains to be traded. Furthermore, the usefulness of the performance statistic comparable with Coles is also questioned, given is it excludes items such as cannibalised stores, underperforming closed stores and includes new store from the 13th month of operation.

While the business is clearly improving, Credit Suisse wonders whether the competitive environment is stabilising enough to allow for meaningful margin expansion over the medium term. Price deflation is still uncomfortably high but competitors seem similarly positioned.

While shareholders can expect an improved balance sheet, a material return of capital is probably not defendable, unless the sale of the fuel business proceeds. The broker now believes the stock is at a fair price and upgrades to Neutral from Underperform, acknowledging it is probably more cautious than many others because of persistently high deflation in the core grocery business.

Morgans is impressed with the turnaround over the last 18 months but believes this is well and truly factored into the share price. As market expectations are high, the broker believes there is downside risk if the company cannot maintain its outperformance against Coles, given it will now cycle more difficult comparables versus its main competitor. Citi agrees further evidence of sustainable sales growth is required before material upgrades to earnings estimates can be made.

Big W

Big W returned to growth. On face value this is a remarkable improvement, in Credit Suisse's opinion, within a short space of time. The risk is that there is an unknown contribution from liquidation, a high level of price investment and no information on the gross margin. That said, the broker acknowledges expectations were set low and a few more quarters are needed to ascertain just how well the business is progressing.

Deutsche Bank is also not celebrating this just yet. The sales improvement is likely costing considerable margin and the business will probably lose significant money in the foreseeable future. The broker remains a buyer of the stock, on the back of the turnaround in the supermarket business. This should continue to outgrow the grocery market for some time and deliver operating leverage on top of the expansion to the gross margin.

Deutsche Bank continues to forecast a loss of around -$150m for Big W, despite the improving sales trajectory, because of the investments which have been made, noting the CEO was cautious about providing any definitive update ahead of the all-important second quarter.

UBS is more confident around the opportunities that are still available via a more rational market and share gains in grocery, upside to margins in food via labour efficiencies, and the turnaround in Big W. The broker acknowledges there is little confidence to be found in a full turnaround at the discount department store but the early signs are encouraging. From a valuation perspective UBS believes the market is too negative about Big W and/or is discounting the earnings opportunity for the company as a whole.

Voice Of Customer

The company's measure of performance, Voice of Customer (VOC) score, continues to improve across all store-controllable metrics. This measure increased to 83% in the quarter from 81% in the prior quarter, with record scores achieved in fruit & vegetables, queue time, team attitude and availability. Macquarie notes on-shelf availability in fruit & vegetables are the biggest opportunities for further improvement.

Online satisfaction now constitutes 25% of the company's customer satisfaction measure, which is much higher than the actual proportion of sales made online. Customer satisfaction inclusive of online is also higher than in-store only. These features indicate to Deutsche Bank that management is focused on this area as an avenue for growth, including the launch of express deliveries and customer satisfaction regarding price perceptions has clearly increased.

Management was careful to restrict the competitive data set to mainline supermarkets, as Aldi's private-label value proposition is not comparable, and acknowledges there is more work to be done to ensure customer trust every time they shop with Woolworths. Deutsche Bank did not get any sense that the company was about to embark on another round of price investment and remains hopeful that price perception can continue to improve on the back of investments already made.

FNArena's database shows three Buy ratings, two Hold and three Sell. The consensus target is $26.18, signalling 0.3% in downside to the last share price. Targets range from $22 (Morgan Stanley) to $29 (Ord Minnett, Deutsche Bank).

This stock is not covered in-house by Ord Minnett. Instead, the broker whitelabels research by JP Morgan.

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