Is the Woolworths Limited share price a buy?

Credit: Woolworths

The Woolworths Limited (ASX: WOW) share price has been fairly volatile for a business that is meant to be a defensive share. Over the past five years it has dropped from nearly $35 to today’s $26.76, although it has risen from nearly $20.56 in the middle of 2016.

So, what was the cause of these price changes?

Woolworths and Coles, owned by Wesfarmers Ltd (ASX: WES), used to essentially run a duopoly in the supermarket business. Then along came German supermarket Aldi. The ‘foreign invader’ was seen as a bit of a gimmick with its funny brands and low-quality décor.

Aldi’s business model is extremely competitive. Aldi doesn’t need to have shelf space for four different brands of tomato sauce in lots of different sizes. It only has one type. If you replicate this across every product category Aldi is able to save a lot of money through smaller stores, less employees and so on.

Aldi is able to offer products at a much lower cost because of its model. It expanded its number of stores and started taking market share from Woolworths and Coles. Eventually Aldi was large enough that Woolworths and Coles had to start reducing prices to compete, which hurt margins.

Woolworths was losing to Aldi and Coles, which is why the share price drifted so low in 2016. Management tried various things to turn it around like its ‘cheap, cheap’ campaign, which didn’t do so well. But the new chairman Brad Banducci had a strategy to re-focus on the customer, reduce prices and improve service.

Since then the Woolworths food sales have increased by a faster rate than Coles for the last several quarters. Over the past four quarters Woolworths has grown food sales by more than 4.7% each quarter and the comparable store sales grew by at least 4.3% in each quarter.

The growth of sales has helped improve the Woolworths margins. In the recent half-year result to 31 December 2017 the gross margin increased to 28.8% from 28.3% and the earnings before interest and tax (EBIT) margin increased to 4.7% from 4.4%.

The key to Woolworths’ future profit growth is if it can maintain (or increase) its profit margin whilst growing sales. Aldi is continuing to decrease prices but it isn’t winning market share as quickly as it used to. It will also be extremely important for Woolworths to grow its online sales too.

Foolish takeaway

In my opinion Woolworths has done very well over the last couple of years but it has probably already picked the low-hanging fruit to improve. If Woolworths has to reduce prices to grow further this could hurt margins.

Woolworths is currently trading at 20x FY19’s estimated earnings with a grossed-up dividend yield of 4.96%. Woolworths is a good business but I don’t think it will be a market-beater over the long-term. If Amazon expands into the food business in Australia then Woolworths could suffer further margin compression.

Instead, I’d much rather invest in these top stocks over Woolworths.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. 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 Scott Phillips.

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