3 reasons I think the Woolworths Limited share price is overvalued

Credit: Woolworths

The Woolworths Limited (ASX: WOW) share price has grown by 15% over the last three months, but is it a buy?

Woolworths owns the supermarket under the same name and it also owns Dan Murphy’s, BWS, Big W and ALH Group. Woolworths has a market capitalisation of $34 billion.

Here are my three reasons why I don’t think Woolworths is a buy at this price:

Supermarket margins are declining

The supermarket may have seen sales increase by 2.8% in its half-year results to 31 December 2016, but the earnings before interest and tax (EBIT) declined by 13.9%.

The profit margins achieved are extremely important when the Woolworths supermarket revenue figure is over $18 billion. Management are making more commitments to reduce prices, so I can’t see margins increasing any time soon.

The supermarket’s decline is a large reason why the earnings per share of continuing operations declined by 18% and the dividend declined by 22.7%.

Other businesses are not helping much

The Endeavour Drinks Group (which contains Dan Murphy’s) saw EBIT grow by 3.1%. This is a respectable result, but only resulted in an additional $9 million EBIT to add to the group’s total.

The New Zealand Woolworths business saw EBIT fall by 4.5%. Big W saw EBIT fall by 137.3% to a loss of $27.2 million.

There is no strong profit growth by any Woolworths business. At least Wesfarmers Limited (ASX: WES) has both Bunnings and Kmart growing earnings strongly.

Increasing competition

Woolworths is going to see increasing competition for its businesses. Aldi, Costco and potential other newcomers will challenge margins even further. Kmart, Amazon and other international stores will challenge Big W even further.

Without investing significant amounts of money, I cannot see a way for several of Woolworths’ businesses to break out of the current malaise.

Foolish takeaway

Woolworths is currently trading at 22x FY17’s estimated earnings, which is quite expensive for a company whose main business is going backwards. It has a grossed-up dividend yield of 3.63% which isn’t very high.

I think Wesfarmers is a much better buy than Woolworths at these prices. However, I wouldn’t buy either of these retail giants. Instead, I’d want to go shopping for these three strong blue chips.

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Motley Fool contributor Tristan Harrison has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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