In the latest half-year reports released by both Wesfarmers Ltd (ASX: WES) and Woolworths Limited (ASX: WOW), eagle-eyed readers might have spotted significant declines in petrol volumes (number of litres sold) at both companies.
Although petrol makes up a small portion of company earnings, continued earnings declines are concerning because both Woolies and Wesfarmers continue to open new petrol outlets, potentially pouring valuable funds into weak opportunities.
(For more information on the decline in petrol volumes you can read my earlier article here).
There are several things you need to know about the decline:
- Return on Equity (ROE)
This essentially means how much money you make back on an investment. If I put my savings in the bank, I'm essentially making around 2-3% ROE, depending on the interest rate of my savings account.
In return for the higher risk of investing in shares, investors expect a higher return on equity. With Woolworths and Wesfarmers opening numerous new petrol stations despite the total size of the petrol market growing 2.1% between 2010 and 2012, shareholders are likely to see a shrinking return on equity.
At 2.1% growth every two years, Woolies and Wesfarmers are literally better off keeping their money in the bank – but the situation is not that simple, as you will see below.
- Competition
Woolworths and Wesfarmers have been playing a giant game of chess for years now, each trying to outdo the other with store locations.
Essentially each company appears to be trying to 'checkmate' the other by ensuring that neither can derive advantage from having the only hardware or grocery store in that location.
In fact fellow writer Mike King wrote that the growth in supermarket store numbers was potentially unsustainable in his article, here.
That goes double for petrol outlets, with Coles opening 12 new sites (for a total of 652) and Woolworths opening 49 (total of ~551) in the first half of 2015.
Woolworths was previously way ahead in the number of outlets, but changes to their alliance with Caltex Australia Limited (ASX: CTX) drastically reduced the number of Woolworths-operated sites.
- Convenience
Despite the potential for shrinking return on equity, both Woolworths and Wesfarmers are seeing decent growth in 'convenience' (non-fuel) earnings from their petrol outlets, and continued investment in these stores appears to be an attempt to increase total earnings through volume.
It might work, if enough convenience items can be sold to make wearing the continued declines in petrol volumes worthwhile. After all, cars aren't going away any time soon.
To sum up, Woolworths and Wesfarmers appear to be opening new stores in order to check-mate their opposite number, whilst simultaneously hoping to increase convenience earnings enough to make it worthwhile and perhaps achieve an 'economy of scale' with the sales.
In doing so, they're running the risk of seeing declining returns on equity, as the size of the total Australian fuel market (and logically the number of trips to the petrol station) is fairly stagnant.
Time will tell whether their strategy works or not, but with such tight competition forcing both companies to eke out fractions of a percent improvement in their businesses, it will be interesting to see how long heavily declining petrol volumes are tolerated.
