Top Shelf | Woolworths Group (ASX:WOW) Share Recommendation

Ord Minnett Research Recommendation:   Woolworths Group (ASX: WOW)  

Woolworths Group reported first-half FY22 earnings before interest and tax (EBIT) of $1.38bn, 2.7% ahead of Ord Minnett’s forecast, with food EBIT of $1.22bn at the top end of the guidance range. The underlying net profit of $795m was 16% ahead of our forecast due to a lower than expected tax rate and finance costs following the Endeavour Group (EDV, not rated) spin-off and capital return. A fully franked interim dividend of 39cps was declared, in line with our expectation.

Management has continued to deliver both higher sales growth and cost growth in the first half relative to Coles Group (COL, Hold). These trends are directly linked, as Woolworths’ higher rates of spending are driving a superior customer offer in our view, both in-store and online.

Woolworths saw 10% cost growth in the supermarkets division, in direct contrast to Coles, which saw 3% growth in cash costs of doing business (CODB). We see four key factors are driving this 700-basis-point (bp) gap:

• Coles’ Smarter Selling cost-savings program versus no cost-savings program for Woolworths (330bp);
• Accounting of supply chain costs, as Woolworths has a significant portion of supply chain costs in CODB, while Coles has this in cost of goods sold (140bp);
• Online investment/mix (100bp); and
• Woolworths’ faster store growth (50bp).

We expect Woolworths’ cost growth to remain around 10% in the second half due to higher COVID-related costs, variable costs and ongoing investment. The gap to Coles is likely to narrow, however, as we expect Coles to see cash CODB growth of 7% in that period.

Although Woolworths’ costs are high, this is contributing to superior sales momentum. Woolworths’ sales growth has continued to outperform relative to Coles by 1–2ppt – on both a year-on-year (YoY) and compound annual growth rate basis – versus pre-COVID levels.

The grocery industry is proving rational as the wave of inflation gathers momentum. Shelf prices increased 2–3% YoY in the first seven weeks of this quarter. This likely understates true inflation, as a large number of promotions were removed in January in response to availability challenges. We expect inflation to increase to 3.1% in 3Q22 before peaking at 4.6% in 1Q23.