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Woolworths Limited ( WOW )

A refreshing display of humility


Recommendation: Accumulate
Investment Rating
WOW has an enviable track record with well above average EPS and DPS growth driving exceptional total returns over the past decade. This reflects well on operational and shareholder focus. Project Refresh is a great success capturing over $9bn in cumulative savings with another $1.5bn to come through further logistics and development initiatives. WOW is a defensive growth stock with a solid balance sheet and an imposing moat surrounding its economic castle. WOW deserves a premium multiple.
03 November 2011
Recommendation Trigger Guide

Note: Marker indicates price of $23.91 at publication date.

Snapshot Last Price Market Cap. 52 Week High 52 Week Low Shares on Issue Sector Moat Rating Intrinsic Valuation Risk Business Risk Pricing Risk Company Beta Sector Beta Low Medium 0.66 0.66 $23.91 $29,278 million $28.94 $23.21 1,224.5 million GICS - Food/Staples Wide $29.05

Event

The consumer electronics category, specifically Dick Smith, is under strategic review with a report due by February. After opening 21 new Australian supermarkets in FY11 (Coles 11) the pace accelerates with 25 to open in 1H12 and 39 for the full year (Coles est.13). This is an extremely aggressive and planned expansion of trading area with the goal longer-term shareholder value creation. A potential $2.5bn in additional annual sales is targeted which if achieved would see fresh sales around $12bn.

Investment Fundamentals Year-end Jun NPAT ($m) EPS () EPS Growth (%) PE Ratio (x) DPS () Dividend Yield (%) Franking (%) FY10A FY11A FY12E FY13E 2,020.8 2,124.0 2,230.0 2,420.1 163.2 173.6 181.6 196.0 8.3 6.4 4.6 7.9 16.9 15.7 13.2 12.2 115.0 122.0 127.0 135.0 4.2 4.5 5.3 5.6 100 100 100 100

Impact

While admitting the near term headwinds will likely see subdued trading through the remainder of FY12 long-term aspirations the focus is on high single digit sales growth and 10% EPS growth assisted by bolt-on acquisitions and capital management initiatives. We will look further into the OBrien strategy and report shortly. At this stage we retain our NPAT estimates for FY11 and FY12. Fair value is unchanged. The EPS growth target is well below that of the past decade of 18% and may disappoint.

Source: Morningstar analyst estimates. Price Chart

Recommendation Impact
No change.

Business Description Woolworths (WOW) is a retailer with primary activities in Supermarkets - Food & Liquor - these represent the majority of group sales and EBIT. Other operations include: BIGW discount department stores; Consumer Electronics through Dick Smith, Powerhouse and Tandy; Petrol through the Woolworths/Caltex alliance; and Hotels following an active acquisition program. Supermarkets are also operated in New Zealand.

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Woolworths Limited (WOW)


Event Analysis
CEO Grant OBrien firmly nails his colours to the mast of Woolworths of the future not the past or the present. While commentators and analysts compare current performance to the past or to the main competitor the real challenge is to compare the Woolworths of today against the Woolworths of the future. This is a future to be driven and directed by OBrien and his management team, many who are new recruits. We doubt Wesfarmers Richard Goyder or Coles Ian McLeod are trembling but this is a fresh approach and it is too early to write it off as more motherhood. The retail environment altered dramatically in the past few years driven by changed consumer behaviour brought on by household deleveraging post GFC and the rapid expansion of online platforms. Over the past decade successful retailers wrested control of the shelves, the supply chain and customer data from suppliers. But in the future the customer will be even more in control and retailers will have to rapidly translate changes in consumer behaviour into effective decision making in order to succeed. We argue the customer has always been in control but perhaps has not exercised it as quickly given massive technology change. The worm has turned and the reaction of retailers will be critical to future success. Interestingly OBrien will not run WOW for short-term shareholder returns. A commitment to a strong level of capital investment to drive long-term growth and value creation is critical to ensure the footprint grows and future customer demands are satisfied. After opening 21 new Australian supermarkets in FY11 (Coles 11) the pace accelerates with 25 to open in 1H12 and 39 for the full year (Coles est.13). This is an extremely aggressive and planned expansion of trading area with the goal longer-term shareholder value creation. While management focuses on minimising the short-term impact it is likely comparable store sales growth will reflect some cannibalisation. While admitting the near term headwinds will likely see subdued trading through the remainder of FY12 long-term aspirations the focus is on high single digit sales growth and 10% EPS growth assisted by bolt-on acquisitions and capital management initiatives. The EPS growth target is well below that of the past decade of 18% and may disappoint. Clearly the costs associated with the establishment of Masters in the $40bn home improvement segment will dampen profit growth but assist sales growth over the next three years. Planned openings are at the rate of one new store on average every three and a half weeks an annual rate of 15 which is similar to the Bunnings expansion plans. The first battle between customer and retailer may be fought in the grocery isles. The intention is to double the penetration of house brands Home Brand, Macro and Select. This can only occur by aggressively increasing shelf space - and the retailers control the shelves. We estimate these brands currently represent near 20% of WOWs packaged grocery sales. While they may appeal to the new frugal consumer there are rising concerns over the percentage of imported product in the category which could delay the intended penetration. House brand liquor is also set to lift profile. In the fresh space, where WOW has clear leadership, management see opportunities to lift market share. A potential $2.5bn in additional annual sales is targeted which if achieved would see fresh sales around $12bn. We will monitor progress in this higher margin category. The consumer electronics category, specifically Dick Smith, is under strategic review with a report due by February. Our thoughts are a complete exit or folding appropriate parts into BIG W and Masters. We will look further into the OBrien strategy and report shortly. At this stage we retain our NPAT estimates for FY11 and FY12. Fair value is unchanged.

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Woolworths Limited (WOW)


Investment Perspective Thesis (Last Updated: 25/08/2011)
Woolworths (WOW) is Australias premier major retailer- operating supermarkets, discount department stores, consumer electronics and more recently hardware and home improvement stores. It has an enviable sales and earnings track record. Market capitalisation exceeds $33bn with annual sales of $54bn. Compound annual growth rates around 17% for EPS and DPS has driven exceptional total returns over the past decade. This reflects well on managements operational and shareholder focus and is responsible for its premium rating. Woolworths is a growth stock with significant defensive qualities - the best of both worlds - has a strong balance sheet and a wide moat characterised by an extensive store network serviced by an efficient supply chain operation coupled with intimidating buying power. EPS growth has exceeded 15% per annum over the past 15 years. Dividend growth has matched earnings growth. The defensive necessity-categorised Food and Liquor Group generates over 75% of group revenue and profit. While it operates in the very competitive supermarket and discount department store segments of the retail sector it has been able to persistently widen trading or EBIT margin, lift profitability, generate substantial free cash flow, improve key financial ratios, reward shareholders and create significant shareholder wealth. Risks involve changes in the Australian retail landscape. The change in ownership of Australias largest retailer, Coles Group, with significant supermarket and discount department store operations and the potential entry of the US-based Costco into the Australian retail sector could raise the competitive bar in the future. The aggressive expansion of Aldi also raises the competitive pressure. A reduction in the rate of growth in consumer spending would also impact revenue growth and could impact operating margins. WOW is a defensive growth stock with a solid balance sheet and an imposing moat surrounding its economic castle. WOW deserves a premium multiple.

Valuation (Last Updated: 25/08/2011)


Fair value of $29.05 is based on a PE of 16x FY12 EPS. Whilst a high PE multiple, it compares favourably with the long term compound annual growth rate above 17% for both EPS and DPS. The reliability, predictability and transparency of the earnings stream provide significant additional comfort. The solid business model combined with first class management results in a justified premium rating. Active capital management initiatives add to the dividend stream resulting in a well above average total shareholder return over the past 15 years.

Risk (Last Updated: 25/08/2011)


Woolworths gains comfort from having the lowest cost-of-doing-business ratio in the supermarkets and discount department store segments. However the change in ownership of Australias largest retailer Coles Group - with significant supermarket and discount department store operations, the aggressive expansion of Aldi and the recent entry of US-based Costco into the Australian retail sector could raise the competitive bar in the future. From a macroeconomic standpoint a reduction in the rate of growth in consumer spending may result in margin pressure although over 75% of group revenue and EBIT is derived from the necessities or supermarket operations that are serviced by a very efficient supply chain based on strategically located regional distribution centres.

Strategy (Last Updated: 11/05/2011)


Since re-listing in 1993 Woolworths has been one of Australia's most successful and consistent retailers. Success has been driven by the adoption of the 'Fresh Food People' and 'Everyday Low Prices' strategies. To continue to achieve well above average earnings growth,

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Woolworths Limited (WOW)


management realised the 'Everyday Low Prices' had to be matched with 'Everyday Low Costs'. The launch of Project Refresh in 2000 addressed the situation with a focus on reorganisation, line items and end-to-end supermarket supply chain improvements. In 10 years cumulative cost savings of over $8.0bn have been achieved, which has driven the Cost-of-Doing-Business (CODB) to sales ratio to around 20%. Further cost savings will be achieved as the focus switches to the non-food sector and regional and national distribution centres are rationalised. The Quantum project has been launched with a focus on all aspects of the business with benefits in both gross margin and CODB to emerge through 2015. could impact operating margins.

The entry into home improvement could deflect management from the supermarket engine.

Financial Overview
Growth

We forecast sales growth (excl. Petrol), around 5% driven by reasonable comparable store sales growth and well planned expansion across Supermarkets and General Merchandise. Acquisitions will add to anticipated organic growth as will the entry into hardware/home improvement.
Profitability

Bull Points

WOWs dominant position in the supermarket sector is entrenched and coupled with first class management ensures it will maintain leadership in the sector. With the lowest cost-of-doing-business ratio WOWs operating margins are the highest driving cash generation which funds expansion and acquisitions while allowing management to entertain capital management initiatives. Above average expansion of supermarket trading area and the roll-out of the new 2015 store format with significantly increased space allocation for fresh product should lift sales growth and margin.

We forecast EBIT growth of around 6%-7%% driven by continued margin expansion. Further efficiency gains from the supply chain and ever increasing volumes spread over a relatively fixed cost distribution network should continue to drive improved margins.
Financial Health

Woolworths generates large cash flows with significant negative working capital. Cash flow comfortably finances operating capex. The balance sheet is robust and significant acquisitions are usually debt funded and topped up with equity where required. Excess capital is returned to shareholders.

Bear Points

Australia has too many supermarkets with retail space growing at a faster rate than the population. This is intensifying competitive pressure and will lead to reduced operating margins. Increased competition from a rejuvenated Coles and the potential entry of Costco will raise competition and lower operating margins. Possible regulatory pressure and legislation surrounding predatory pricing

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Woolworths Limited (WOW)


Per Share
Year to 30 June Earnings Dividends Franking % 2009A 150.7 104.0 100.0 2010A 163.2 115.0 100.0 2011A 173.6 122.0 100.0 2012E 181.6 127.0 100.0 2013E 196.0 135.0 100.0

Cash Flow ($M)


Year to 30 June Receipts from Customers Net Operating Cashflow Capex Acquisitions & Investments Sale of Invest. & Subsid. Net Investing Cashflow Proceeds from Issues Dividends Paid Net Financing Cashflow Net Increase Cash Cash at Beginning Exchange Rate Adjust. Cash at End 2009A 53,225.9 2,604.2 -1,678.2 -154.5 --1,806.2 66.7 -1,041.6 -808.9 -10.9 754.6 3.0 746.7 2010A 55,664.6 2,759.9 -1,817.7 -214.5 4.2 -1,960.1 153.3 -1,181.4 -832.9 -33.1 746.7 -.2 713.4 2011A 58,886.6 2,991.1 -2,123.2 -443.9 --2,177.4 274.3 -1,273.2 -.7 813.0 713.4 -6.8 1,519.6 2012E 57,038.7 3,205.3 -1,447.0 ---1,447.0 --1,559.6 -1,758.3 -1,519.6 -1,519.6 2013E 61,115.0 3,431.6 -1,519.3 ---1,519.3 --1,667.2 -1,912.3 -1,519.6 -1,519.6

Profit & Loss ($M)


Year to 30 June Sales Revenue EBITDA Depreciation & Amort. EBIT Net Interest Expense Profit Before Tax Tax Adjusted NPAT Reported NPAT 2009A 2010A 2011A 2012E 2013E 49,739.4 51,964.1 54,505.7 57,100.0 61,200.0 3,577.9 3,895.6 4,111.8 11.8 7.1 -729.4 -797.7 -857.9 920.0 960.0 2,848.5 3,097.9 3,253.9 3,449.9 3,720.2 -222.2 -227.3 -277.0 285.0 290.0 2,626.3 2,870.6 2,976.9 3,164.9 3,430.2 -766.3 -832.6 -874.6 -920.0 -995.1 1,835.7 2,020.8 2,086.0 2,230.0 2,420.1 1,835.7 2,020.8 2,124.0 2,230.0 2,420.1

Growth
Year to 30 June Sales Revenue EBIT EPS DPS % % % % 2009A 5.2 11.8 11.7 13.0 2010A 4.5 8.8 8.3 10.6 2011A 4.9 5.0 6.4 6.1 2012E 4.8 6.0 4.6 4.1 2013E 7.2 7.8 7.9 6.3

Balance Sheet ($M)


Year to 30 June 2009A 2010A 2011A 2012E 2013E Cash & Equivalent 762.6 713.4 1,519.6 1,519.6 1,519.6 Receivables 466.5 691.2 889.2 1,183.5 1,268.5 Inventories 3,292.6 3,438.8 3,736.5 3,926.9 4,192.3 Other Current Assets 337.5 318.3 353.8 214.7 214.7 Current Assets 4,859.2 5,199.0 6,593.0 --Prop. Plant & Equipment 6,653.9 7,639.1 8,620.3 9,267.1 9,946.2 Intangibles 4,933.1 5,071.0 5,236.6 5,116.8 4,997.0 Other Non-Current Assets 636.0 564.9 629.7 644.6 644.6 Total Non-Current Assets 12,225.7 13,288.3 14,501.5 --Total Assets 17,084.9 18,487.3 21,094.5 21,873.2 22,782.9 Interest Bearing Debt 3,174.9 3,542.1 4,844.9 4,646.2 4,401.1 Other Liabilities 6,852.7 7,127.5 8,403.8 8,710.8 9,112.7 Total Liabilities 10,027.6 10,669.6 13,248.7 13,357.0 13,513.8 Net Assets 7,057.3 7,817.7 7,845.8 -8,516.2 -9,269.1 Total Shareholders Equity 7,057.3 7,817.7 7,845.8 8,516.2 9,269.1

Ratios
Year to 30 June Price/Earnings EV/EBITDA Dividend Yield EBITDA Margin EBIT Margin Net Profit Margin ROE ROA ROIC Net Debt/Equity Interest Cover % % % % % % % % % % x 2009A 17.6 9.7 4.0 7.2 5.7 3.7 27.0 11.9 21.4 34.2 12.8 2010A 16.9 9.3 4.3 7.5 6.0 3.9 26.7 12.0 20.7 36.2 13.6 2011A 15.9 9.0 4.4 7.5 6.0 3.8 27.5 11.0 20.6 42.4 11.7 2012E 13.2 7.5 5.3 7.7 6.0 3.9 28.3 10.4 20.5 37.8 12.1 2013E 12.2 7.0 5.6 7.7 6.1 4.0 28.2 10.9 21.3 32.0 12.8

Top 5 Substantial Shareholders


No Substantial Shareholders

Principals & Directors


Principals

Company Secretary

Mr Peter J Horton

Previous Research
27/10/2011 17/10/2011 08/09/2011 25/08/2011 28/07/2011 22/07/2011 21/07/2011 18/04/2011 10/03/2011 03/03/2011 25/02/2011 25/01/2011 24/01/2011 08/12/2010 20/10/2010 16/09/2010 13/09/2010 1Q sales disappoint Oh Oh Oh OBrien Price trigger adjustment Retaining positive stance FY11 below expectation guarded outlook A closer look at 4Q and FY11 sales performance Full-year sales result confirms good health 4Q sales 3Q sales growth at the higher end of the expected band Discretionary spending concerns addressed Engine room continues to deliver Impressive margin gains in Australian Food & Liquor Able to deal with competition Earnings downgrade as discretionary spending slides Headwinds in the near term but the model is not broken! Its a struggle in retail land! Not keen on participation in share buy-back Off-market share buy-back

Directors

Ms Jillian Rosemary Broadbent(Non-Executive Director) Mr James Alexander Strong(Non-Executive Director,Non-Executive Chairman) Dr Roderick Sheldon Deane(Non-Executive Director) Mr Leon Michael L'Huillier(Non-Executive Director) Mr Michael Luscombe() Ms Alison Mary Watkins() Mr Ralph Graham Waters(Non-Executive Director) Ms Jayne Hrdlicka(Non-Executive Director) Mr John Frederick Astbury(Non-Executive Director) Mr Thomas (Tom) William Pockett(Finance Director) Mr Ian John Macfarlane(Non-Executive Director) Mr Grant O'Brien(Deputy Chief Executive Officer)

2011 Morningstar, Inc. All rights reserved. The data and content contained herein are not guaranteed to be accurate, complete or timely. Neither Morningstar, nor its affiliates nor their content providers will have any liability for use or distribution of any of this information. To the extent that any of the content above constitutes advice, it is general advice that has been prepared by Morningstar Australasia Pty Ltd ABN: 95 090 665 544, AFSL: 240892 (a subsidiary of Morningstar, Inc.), without reference to your objectives, financial situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making any financial investment decision. If applicable investors should obtain the relevant product disclosure statement and consider it before making any decision to invest. Some material is copyright and published under licence from ASX Operations Pty Limited ACN 004 523 782 ("ASXO"). DISCLOSURE: Employees may have an interest in the securities discussed in this report. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf.

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Woolworths Limited (WOW)


Research Methodology
We seek undervalued stocks with a medium to long-term investment time horizon. Companies that make the best investments tend to be those able to grow earnings per share year after year and which are able grow at rates above the average of the market. Earnings growth supports a solid and growing dividend stream which is the essence of shareholder return. In searching for the best businesses in the market, we want to see an ability to turn revenue into profits and a record of strong returns to equity. The ability to generate strong free cash flow is critical as this is where the funds come from to pay dividends or to invest in new growth areas. The greatest free cash flow generators will have strong margins, good controls over working capital and limited requirement for capital expenditure. The best businesses will also have robust balance sheets including a not onerous level of debt. We believe in strong, experienced and disciplined management. We ascribe a moat rating to each stock researched: Wide, Narrow or None. The moat is the competitive advantage that one company has over other companies in the same industry. Wide moat firms have unique skills or assets, allowing them to stay ahead of the competition and earn above-average profits for many years. Returns on their invested capital will exceed the cost of that capital. Without a moat, highly profitable firms can have their profits competed away. Other companies will see how attractive the market is and try to move in to reap some of the rewards themselves. Sources of economic moats include innovation skills or first mover advantages, a superior cost position, the ability to provide a range of products to suit the needs of a variety of markets, high switching costs or locking out of competitors. The moat rating is just one of the ingredients used in determining whether a company is undervalued, though it is obviously an important one. We are not saying that no-moat companies should be avoided. Simply, the very best long term investments are in wide moat firms bought when they are undervalued.

Business Risk
Business risk encompasses all operational risk and financial risk. Companies with low business risk have the most reliable earnings streams. A change in business conditions may reduce earnings predictability and therefore increase risk. Examples are market entry of a new competitor, unfavourable shifts in the economy, changes in key management personnel, major investment in an uncertain new venture or acquisition, and increased interest burden caused by higher debt levels or raised interest rates.

Pricing Risk
Pricing risk reflects the premium or discount implied in the current price of the shares. Many growth stocks trade on high earnings multiples giving them high pricing risk though they may have low business risk. Investors should consider their risk tolerance before investing in the share market. Many investors will decide to have only low risk stocks in their portfolio though others will accept higher risk levels in order to pursue higher returns.

Recommendations
Our qualitative recommendations simple and easy to understand: are

Buy: Suitable for purchase now Accumulate: Undervalued but there is time to purchase Hold: Appropriately priced, neither buy nor sell Reduce: Sell part holding Sell: Sell all holdings now Avoid: Not investment grade

Intrinsic Value
Intrinsic Value (otherwise known as Fair or Underlying Value) is the analyst's interpretation of what the stock is worth today. The stock is considered to be undervalued when the quoted price is below this point or overvalued where the price is above it. Whether to invest in a stock will depend on consideration of the prospective return and the risk undertaken. Prospective return includes both share price moves and dividend yield. Our analysts incorporate the stock's risk in their intrinsic value. Other things being equal, lower risk stocks will have greater intrinsic value than higher risk ones. A stock becomes a buy when the quoted share price is at a discount to intrinsic value that provides a sufficient prospective return.

Economic Moats
The pursuit of high quality businesses is central to our investment philosophy. These offer the greatest gains to the long term investor, so long as they are bought at a reasonable price. The concept of economic moats is valuable in assessing the quality of a business, with the phrase popularised by Warren Buffett and Charlie Munger. Just as wide moats protected castles from invaders in medieval times, businesses with wide economic moats have strong defences against their profits being competed away.

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