The Aussie economy is currently undergoing a major transition from being a mining-led economy to one which is more balanced and relies to a greater extent upon other industries. Clearly, such a change is never going to be easy and it brings with it a considerable amount of uncertainty. For example, there are real concerns that Australia will endure a recession in the short run, while unemployment levels remain higher than desired.
As a consequence, the outlook for the consumer sector is relatively downbeat. Various indicators continue to point to weak consumer sentiment and, while falling interest rates may help to offset the reduced spending power of the Aussie consumer, investor sentiment in consumer-focused stocks such as Woolworths Limited (ASX: WOW) has been falling, with the supermarket major seeing its share price slump by 23% in the last year.
However, where Woolworths continues to have great appeal for investors is with regard to its yield, which presently stands at a fully franked 5.2%. That's 60 basis points higher than the ASX's yield and, with Woolworths increasing dividends per share at an annualised rate of 10% during the last decade, many investors may be contemplating buying a slice of the business to provide an improved income as interest rates fall.
Woolworths' earnings, though, are due to come under sustained pressure as disposable incomes are squeezed.
The upshot of this is likely to be an increase in the popularity of discount retailers such as Aldi and Costco, with Woolworths already being drawn into a price war as it invested $200m in pricing in the second half of financial year 2015. And, with Woolworths' earnings due to fall by 7.5% per annum over the next two years, headroom when making dividend payments is set to decline.
Despite this, Woolworths is still due to have a dividend coverage ratio of 1.2x in financial year 2017. And, while discounts are becoming more prominent, Woolworths is also on-target to deliver $500m in cost savings as it seeks to become a leaner operation. As such, its margins over the medium term may hold up better than the market currently anticipates and cost reductions may allow the company to hold its ground on price versus no-frills operators.
Clearly, Woolworths is not as defensive as many investors believed, with its top and bottom lines offering little in the way of stability in the next couple of years. However, if the ASX resumes its downward spiral following gains in recent weeks, Woolworths' beta of 0.67 means that its shares are likely to hold up much better than the market, as well as offering a reduced volatility shareholder experience.
So, while Woolworths is undoubtedly experiencing a difficult period and its shares could come under pressure in the short run, its long term potential as an income play appears to be relatively sound. It has a high, well-covered yield, cost savings to come through, offers reduced volatility versus the ASX and, crucially, trades at a discount to the ASX through a price to earnings (P/E) ratio of 14.2 versus 15.5, thereby indicating upward rerating potential over the medium to long run.
