A home renovation challenge for Woolworths

There's a reason why Woolworths produced its first material decline in profitability in memory today, but underlying a result marred by the decision to offload the Dick Smith consumer electronics business are some significant challenges for Grant O'Brien.

The previously announced $300 million writedown of the Dick Smith business, in preparation for an exit from the category, drove the statutory result down 16.8 per cent and represents a rare acknowledgement of retail failure in Woolworths' modern history (A rare admission of Woolworths failure, January 31).

Even setting that to one side, however, the underlying result – a 3.2 per cent increase in earnings from continuing operations – is lacklustre by Woolworths' stellar standards and beneath the headline numbers there are some continuing issues for O'Brien, who took over as chief executive last October, that would cause him some concern.

The steady tapering off of the growth rate in Woolworths' sales and earnings in recent years can, perhaps, be explained partly by the difficult external conditions, which have battered not just the Dick Smith business but the more central Big W discount department stores chain. Big W experienced a 4.3 per cent slide in earnings in the half.

Arch rival Coles and its Wesfarmers' sibling Kmart, however, have sales and earnings growing at far greater rates. And while that might be explicable in terms of the low bases from which they are coming, there is a sense of momentum in those businesses that would be disconcerting to a Woolworths team that has been accustomed to significant out-performance.

If it weren't for the constant comparisons, the 6.3 per cent improvement in the earnings before interest and tax of the core Woolworths supermarkets business would undoubtedly be considered respectable in the tough trading conditions for retailers.

A deeper issue for O'Brien, and one that can't be dealt with quickly, is that his group's returns on funds and equity are also sliding, and have been for several years.

After the recent results of the Wesfarmers retail brands there was an interesting discussion/debate about the different macro strategies being pursued by the two dominant retailers. Coles is primarily pursuing a strategy of improving and maximising the profitability of its existing network while Woolworths is engaged in a very substantial expansion of its network that is expected to drive long-term growth in its sales base.

That expansion and refurbishment binge has resulted in Woolworths' capital expenditures escalating in recent years to the point where it has been nudging $2 billion a year. This year, despite O'Brien pulling back planned spending by about $180 million, it expects to spend $2.24 billion.

Not surprisingly, given that the aggressive expansion of its store networks – and the decision to attack Bunnings' dominance of the hardware sector – were conceived during a period when Woolworths totally dominated the sector and was stripping sales and earnings from its then destabilised rival, the loss of momentum in its core means that the dollars being poured into expansion are now impacting Woolworths returns.

The group's return on funds fell 164 basis points in the latest half, to 15.4 per cent if the Dick Smith business is excluded. About 94 basis points of that decline is attributable to the early impact of the Masters hardware business. Given that Woolworths only has 7 of those stores operating but has plans to roll out a 150-store big box chain over five years, that decision to enter the hardware sector will weigh on returns for some time.

Woolworths' return on equity, even after last year's $1 billion of share buybacks, was down from 16.05 per cent to 14.62 million, again excluding the impact of Dick Smith. Because of the conditions there will be no more capital management this financial year.

Woolworths' returns have now been sliding for several years. The obvious response would be to sell-off or spin-out some of its properties to reduce the capital intensity of the business and O'Brien does plan to do that, but this year the group only expects about $200 million of property sales.

It is an interesting, but academic, question as to whether Woolworths would have embarked on such an aggressive expansion of its floor space, or decided to tackle the powerful Bunnings franchise on its home turf, had it anticipated the rate and extent of the resurgence of Coles and Kmart or foreseen the sea-change in retail conditions generated by the global financial crisis and its particular impact on Big W and Dick Smith.

Woolworths, of course, remains an exceptional business generating exceptional margins but it now has a couple of cylinders miss-firing and some medium-term challenges to turn around the trends in its returns.

O'Brien's approach – apart from the decision to dump the Dick Smith chain – is relatively low key and introspective, focusing on sharpening the group's marketing, increasing the amount of direct sourcing, increasing the proportion of home brands, continuing to work on the productivity of his supply chain and working his existing asset base harder.

In the end, however, his legacy will be defined by his ability to get the group generating the kinds of returns the market used to be accustomed to and by the success, or otherwise, of the drive into hardware. While he inherited that decision, given that he played the key role in developing the hardware strategy, his reputation is enmeshed with the outcome.