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The Shelf War

Australians it seems have a mighty thirst for ‘two buck chuck’.

Alcohol sales for Woolworths was the sales category with the fastest growth for the company in the past 12 months.

Total Australian food and alcohol sales were up 3.8% to $37.5 billion, of which alcohol represented an increase of 12% to $6.6 billion.  And what was left over from the Federal Government’s Household Assistance Package looked like it was shoved into the pokie machines at Woolworths’ owned hotels (hotel sales up 4.4% to $1.2 billion).

The figure for food sales is none too flash.  Growth was only 1.9% but the number of supermarkets increased by 3.8% for the year.  It tells the story of costs going up, suppliers being squeezed in the middle, lack of consumer confidence and food category deflation.

Full year Net Profit After Tax (NPAT) is expected at around $1.9 billion on total group sales of $56 billion. Annual dividend is expected to total around $1.23 or about 4.5% fully franked, which in this market, given where term deposit rates are, is not be sneezed at.  Woolies (WOW) price is currently $27.90.

What Woolworths does provide is certainty of earnings. Capital growth looks mediocre at best, particularly as Woolies main competitor, Coles/Wesfarmers (WES) turnaround remains on track.

So what is then the best play in a defensive sector?

Our view is for investors, prepared to take a medium term view, is to invest in Wesfarmers Partly Protected shares (ASX: WESN), compared to investing in Wesfarmers or Woolworths ordinary shares.

Stick with me. The next bit is dry, but demonstrates the inbuilt optionality on WESN and how you can make money if the WES share price goes up or down.  It‘s the best way to maintain exposure to the retail sector and growth of Coles future earnings. And avoid market volatility.

WESN (Partly Protected Shares) were issued in 2007, to then Coles retail investors when Wesfarmers took over the company.

WESN are currently trading around $33.69.

WES is $32.16. The premium of $1.53 reflects the optionality contained in WESN – it comprises a WES share and embedded complex options with barrier and rainbow features.

Market range of the premium WESN trades over WES is between 50 cents and $1.50 – currently trading at the upper end.  Different valuation models (such as Monte Carlo simulations and a host of other assumptions such as dividends etc.) impact on the valuation premium.  Particularly as the WESN shares convert in November 2015, 3.5 years from now.

As the WES share price approaches the rainbow option call, a strike of $34.49,  WESN may trade at even a bigger premium to the current share price. This reflects what I call the “pot of gold” outcome for the rainbow option, where there are two outcomes – lots of money, and more money!

Each WESN has the same dividend payout, voting rights and capital repayments as ordinary shares

So what is the barrier and rainbow option embedded in WESN?

The barrier option takes the form of downside protection.

Example 1

BUY WESN at $33.69

Converts into 1.25 WES shares if the WES VWAP (Volume Weighted Average Price) on conversion is below $34.49.

$33.69/1.25 shares = $26.92.

The VWAP price of WES in Nov 2015 has to fall below $26.92 before a WESN shareholder can lose money (The barrier protection option becomes worthless at $26.92)

Compare this with the current WES share price of $32.16. The WESN offers 20% downside protection before it enters loss territory.

Consider Example 2

BUY WESN @ $33.69

Nov 2015 VWAP = $30.00

WESN converts 1.25 WES = $37.50 ($30×1.25)

($37.50-$33.69) = $3.81 profit

Capital profit $3.81/$33.69 = 11.3% 0r 3.39% pa.

Assume divs $4.80 ($1.60 pa)

Total return is 25% or 8.4% pa.

Outcomes of the Rainbow option – two good outcomes for WESN shareholders. Better and best.

If the VWAP is between $34.49 and $43.11 WESN shares will convert into $43.11 of value made up of ordinary shares.

But above $43.11 WESN will convert into one ordinary WES share.

So the sweet spot for WESN shares versus WES is the leverage they provide if the WES VWAP share price is between $34.39 and $43.11


BUY WESN @ $33.69

NOV 2015 VWAP $37.00

WESN converts $43.11 value = 1.16 shares

($43.11 – $33.69) = $9.42 profit

Capital profit $9.42/$33.69 = 27 % or 8.4% pa

Assume divs $4.80 ($1.60 pa)

Total return is 42 % or 12.6% pa.

In the event Wesfarmers has a blinder performance between now and 2015 and is above $45, the WESN will convert into one ordinary WES share.


Buy WESN @ $33.69

Nov 2015 VWAP = $45.00

WESN converts 1 Ordinary WES share

($45.00-$33.69) = $11.31 profit

Capital profit $11.31/$33.69 = 33.5% or 10% pa.

Assume divs $4.80 ($1.60pa)

Total Return is 47% or 14.35%pa.

The primary benefits of investing in WESN over WES and WOW is:

1) Downside protection during the next 3 years to just under $27.00. Can still make money on WESN even if the WES share price corrects by 20%.

2) Leverage to WES share price upside “sweet spot “between $34.49 and $43.11. Expected share price growth of Wesfarmers could push the price into this band in in the next three years.

3) Risk return profile is conservative, in my opinion. Premium outlay of $1.50 of WESN over WES is justified by potential capital gain of $9.42 in the sweet spot range.

4) WESN carries same div and rights as ordinary WES shares.

5) Significantly higher returns and lower volatility.

All that remains now is for the ageing, flogged out rock band The Quo (Status Quo), to test whether advertising is the art of making lies out of half-truths. Will they sell more loo paper for Coles, with their bastardised jingle – 37 year old version of Down Down?

Rock purists are shuddering!

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