Shares of Woolworths Limited (ASX:WOW) have continued to tumble today following an earnings downgrade yesterday and a raft of analyst downgrades this morning.
In addition to letting go of CEO Grant O'Brien, Woolworths yesterday said that it expects to report a profit result broadly in line with last year before significant items of around $300 million.
Sure enough, analysts have now moved to downgrade their price targets on the diversified retail operator. Targets of $21.00, $28.00, $27.24 and $24.00 have emerged in the financial media.
More alarmingly however is the downgrade from the two premier rating agencies, Moody's and S&P, who both lowered their ratings outlook for the business.
Moody's said its rating change reflected a continued material negative trend in the Australian Food, Liquor and Petrol business, which accounts for 79% of group sales.
The rise of low-cost grocery giants such as Aldi and Costco has been well-documented by the financial media for some time.
Aldi, which is believed to have more than 350 outlets dotted throughout Australia, recently began to challenge the two-decade-long duopoly of Coles — owned by Wesfarmers Ltd (ASX: WES) — and Woolworths. Combined, the two giants control approximately 74% of the $94 billion market.
Aldi is estimated to hold slightly more than 10% share, but has already wreaked havoc on the market's third largest operator, Metcash Limited (ASX: MTS), which doesn't have the ability to compete on price like Woolworths and Coles do.
The overwhelming consensus is that both Coles and Woolworths must accept lower profit margins in the future. The Coles division of Wesfarmers had a profit margin of just 4.5% whereas Woolworths' grocery channel had a margin of 7% in their respective 2014 financial year.
Should you be worried?
Every investor should be cognisant of the risks that a more competitive landscape will bring.
Earlier this week I showed that my fair value estimate for Woolworths shares was around $28.60. This value was based on a 6.8% profit margin within the grocery business in the 2015 financial year (before steadily declining to 6.1% in 2022), 20% sales growth in Home Improvement and a 1% drop in supermarkets.
However, if I lower my group sales forecast to negative 4% in 2015, the supermarket's profit margin to 6.5% (still declining out until 2022), and adjust for the $300 million in significant items, my discounted cash flow valuation drops to $26.44 – its exact market price at the time of writing.
As I wrote earlier, Woolworths shares are not a bargain by any means. Bulls might say there's still plenty more upside in the business. At the moment, however, there's certainly more bears than bulls.
