Woolworths (ASX: WOW) is undoubtedly one of the best companies in Australia. Few businesses can match the long term success achieved by the self-described 'fresh food people', and long term shareholders are far wealthier as a result.
Nonetheless, it is a great danger for investors to simply extrapolate from the past. Although Woolies may have made a lot of people very rich so far, there is no guarantee that this will continue, not least because of the rather hefty premium shares selling for..
And investors may well be right to be sceptical. The grocery giant has already gobbled up almost half of the grocery market, new competitors have entered the fray and moving into new business areas such as hardware are far from simple propositions.
The end of growth? Be careful…
Investors have often dismissed Woolies' ability to grow. And to date, at least, they've been wrong each time: relentless cost control and efficiency gains, category expansion and — at least for much of its history — increasing market share, have helped grow profits from $83 million in 1992, to over $2.4 billion today.
These returns are reflective of some wonderful business characteristics; features that are today as strong, or indeed stronger, as they have ever been. Not least of these is the extraordinary scale advantages that come from the store network and logistics infrastructure, which provide meaningful pricing power as well as potent barriers to entry. Furthermore, the defensive nature of its business mean it enjoys wonderfully dependable cash flows; this is a company that barely feels a recession, or certainly much less severely than most.
Importantly, the strength of its balance sheet and the ability to leverage off its sites and logistics assets has enabled Woolworths to successfully expand into new categories; such as liquor, petrol and most recently hardware.
Where to from here?
Thanks to these wonderful structural advantages, Woolies is a business that should be able to sustain growth that is, at a minimum, broadly in line with population growth and inflation; at least so long as it doesn't lose too much market share. In fact, some modest loss here likely wouldn't be too keenly felt when you factor in ongoing efficiency gains and an increasing contribution from new segments, such as hardware (which although not off to the greatest of starts is likely to be a more meaningful contributor over time).
That is, however, a far cry from the heady profit growth of the past, and for the historical return to be sustained, shareholders need to be either confident that growth will be far greater than what is implied above, or be able to pay a price that accounts for the slowdown in growth.
Although Woolies has undoubtedly silenced its critics to date, the very success of the business has made it progressively more difficult to sustain such robust growth. Once you've expanded into all the obvious categories and have captured a significant chunk of market share, all the low hanging fruit has largely been picked.
It's a brave investor who calls the end of growth for such a strong operator, but the pace of growth will be very difficult to maintain over the long term, at least without taking on greater risk.
