Woolworths Limited (ASX: WOW) is Australia’s largest grocery retailer with a market share of approximately 40%. Woolworths’ food and liquor business make up more than 80% of Woolworths’ total earnings. It is an extremely high quality business, with reliable defensive earnings and only one major competitor, Coles.
The market is currently concerned with losses resulting from the roll-out of the Masters home improvement division. However, to put the home improvement losses into perspective, Woolworths’ earnings before tax from its food, liquor and fuel division were a whopping $3.4 billion for FY14. In comparison, the loss from the Masters division was an immaterial $169 million. Furthermore, the move into home improvement offers substantial upside given the highly fragmented nature of the industry where the current market leader, Bunnings, only occupies a 16% market share.
Although it is unlikely that Woolworths will see the high growth rates it has experienced over the past decade, it will still likely grow earnings at an annual rate of in excess of 10% as a result of the following factors:
1) The huge size and scale of Woolworths’ supply network affords it the lowest costs in the sector which results in high margins and substantial free cash flow.
2) A return of food inflation. Every 1% increase in food inflation results in an approximately 2% increase to Woolworths’ earnings. Food inflation is currently at near record lows and is forecast to increase throughout 2015.
3) Increased earnings growth in the grocery division as a result of recently opened stores continuing to gain customers and recently implemented marketing initiatives and loyalty programs.
4) A profitable howe improvement division. Although Woolworths’ home improvement stores are currently loss making, over the medium term, Masters will be profitable. The market has currently not factored this into the share price given the short-term focus of analysts.
5) Woolworths has invested heavily in new capital expenditure over the last five years, however capital expenditure is now easing and will result in increased cashflow and higher dividends to shareholders.
In addition, Woolworths also pays a reliable and growing dividend, which currently yields 4%. Therefore, investors should see an annual return of 15%, making Woolworths a great long-term investment.
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Motley Fool contributor Bradley Murphy owns shares in Woolworths.