Is Woolworths a Surprise Sleeper Stock?

As awful as it is to live through inflation, all that inflated currency does eventually end up somewhere.

Woolworths (WOW.AX) is Australia’s largest retailer and second largest public company by revenue. Despite that large presence in its home market, Woolworths’ shares still trade below the peak they reached before the COVID-19 pandemic knocked the world’s economy for a loop. Woolworths has lagged even though the overall Australian ASX 200 Composite stock market index has since fully recovered its pandemic-driven losses.

Fortunately for investors, though, how a company’s stock has performed in the past does not determine how it will perform in the future. This is because the market attempts to value companies based on projections of things to come, not just what they have delivered in the past. On that front, Woolworths could very well be a surprise sleeper stock for 2023.

A potential sign of things to come

In its recent earnings release that covered the first half of fiscal year 2023, Woolworths posted a revenue increase of 4% and a basic earnings per share boost above 16%, thanks to improved margins.  Buried in the details of its earnings report are segment-level details that are generally telling a story of inflation -- higher prices offsetting flattish or declining volumes. 

With economic forecasts projecting continuing higher-than-normal inflation throughout 2023, it’s likely those trends will continue. It’s that combination of factors that could lead to Woolworths delivering ahead of expectations.

There are many reasons for this. For one, retailers like Woolworths tend to have high fixed costs -- things like real estate for their stores and warehouses -- that don’t immediately move up with inflation. If those costs hold steady even as inflation forces it to raise the prices of what it’s charging its consumers, that can turn into higher net margins. 

For another, retailers tend to carry inventory based on how fast a product moves off the shelf. If higher inflation continues to translate to softer volumes, that means Woolworths may be able to cut back on its inventory levels without affecting the consumer shopping experience. Less inventory frees up cash otherwise tied up in that inventory, but it can also reduce the need for warehouse space and staffing associated with stocking the stores.

In addition, retailers frequently price their products to give them profit margins based on the percentage of an item’s cost. As inflation raises the price of those items, that pricing logic will lead directly to higher profits per unit sold in Australian dollar terms. 
At the end of the day, that combination of better fixed cost coverage, the ability to lower operating costs with slower unit velocity, and rising per unit profits could very well lead to strong earnings. If that happens for Woolworths, it could turn into a key driver for its stock.

Australia may be relatively resilient to inflation

Although high inflation is never fun to live through as a consumer, Australia’s economy may be better positioned than most to be able to deal with it. This is because mining and resource extraction is a large part of its export-oriented economy. Resource prices tend to rise with inflation -- and in fact, they’re often a driver of it. 

As a result, as long as resource demand remains solid as businesses and consumers bear the costs of inflation, Australia should continue to benefit from its exports selling at higher prices. The cash coming in from those exports is available to support Australia’s domestic economy -- including shopping at retailers like Woolworths. Or in other words, all that inflation eventually ends up as spending somewhere, and there are decent reasons to believe Woolworths should get at least its fair share of it.

Put all those drivers together, and continued inflation could very well be a key driver behind Woolworths becoming a surprise sleeper stock for 2023.

At the time of publication, Chuck Saletta did not own shares of Woolworths.

Woolworths Group Limited

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Sources – EasyResearch, Insider Monkey, Yahoo Finance, Market Index, Woolworths Group, We Forum, Reserve Bank of Australia

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