Woolworths Limited (ASX: WOW) shares have slumped 14.4% in just five days, or a massive 31% in 12 months.
At today's seemingly discounted prices, Woolworths' shares boast a trailing dividend yield of 5.8% fully franked, or 8.35% grossed-up, and trade at a forward price-earnings ratio of 14x (based on consensus earnings estimates).
Some investors may be inclined to believe these are great metrics, especially when compared to the broader S&P/ASX 200 (ASX: XJO) (Index: ^AXJO) average dividend yield of 4.6% and P/E of 15.4x; however, it's important to remind yourself of a few things before buying Woolies shares, including:
- Woolworths' profit is expected to fall hard in the next 12 months and could fall again the year after;
- The dividend may be cut; and
- We may be on the cusp of a grocery price war
The final point above is particularly concerning because it would mean share prices of supermarket operators such as Woolworths, Wesfarmers Ltd (ASX: WES) (the owner of Coles) and Metcash Limited (ASX: MTS) (the owner of IGA and Foodworks) will stay lower-for-longer.
Announcing its 2015 first quarter trading update last week, Woolworths said its half-year profit could fall by as much as 35% as it seeks to invest heavily in order to stem losses from its supermarkets business. That kind of investment will no doubt raise the eyebrows of Coles, Metcash and possibly even Aldi, given that Woolworths has historically produced the widest (i.e. most lucrative) profit margins.
Deutsche Bank analyst, Michael Simotas, was quoted in Fairfax this morning as saying, "The deep earnings reset raises the prospect of a price war, given that Woolworths has less to lose."
A move by Woolworths to dramatically lower prices would have a significant consequence for the grocery market, consumers and shareholders.
Is Woolworths a value trap?
Prior to its recent 2015 results, I said fair value for Woolworths' shares could lie somewhere between $26 and $28. However, my value estimates assumed a modest but perhaps sanguine dive in profit margins within the all-important Australian Food, Liquor and Petrol business.
If I lower my profit margin forecasts to roughly 5.5%, from their current 7.2%, bearing in mind Coles achieves a profit margin of just 4.7%; the implied value of Woolworths' shares drops to $23 using a 3% terminal rate. If I lowered the terminal growth forecast to a more conservative rate of 2%, my estimate of Woolworths' fair value drops to just $19 – 20% lower than today's share price.
Foolish Takeaway
Profit margin estimates play such a big part in the valuation of retailers like Woolworths because they are 'volume' businesses (i.e. they sell millions of products at a very small margin). Therefore, although Woolworths' shares may look cheap using very basic valuation metrics like P/E ratios and dividend yield, if you're not confident its supermarkets can push back against Coles and Aldi without falling into an all-out price war, it'd be best to avoid Woolworths' shares altogether.
