Hardware is the weak spot in Woolworths' solid showing

If it weren’t for the major question mark over the viability of the loss-making hardware strategy and the tough environment for discount department stores, Grant O’Brien would be receiving accolades for what he has achieved so far at Woolworths.

Nearly three years after he inherited the chief executive’s office of a business whose core food and liquor operations were losing ground against a revitalised competitor, O’Brien has real momentum beginning to flow through Woolworths’s key division.

While there was some shifting of the burden of petrol discounts between the group’s food and liquor business and its petrol business, overall the Australian core of Woolworths increased its normalised earnings before interest and tax by 7.2 per cent to $3.4 billion.

If petrol were excluded, food and liquor earnings were 9.1 per cent higher, there was a nine basis-point increase in gross margin and the division’s EBIT margin rose 15 basis points to 6.98 per cent. There are lot of ticks against the performance metrics of the business, which have shown gradual but accelerating improvement since O’Brien became chief executive.

In tandem with the reinvigoration of food and liquor Woolworths has been making a major play in online retailing, with its food and liquor division the main driver so far. Online sales rose by 50 per cent and, at more than $1.2 billion, are starting to become meaningful.

The botched hardware strategy, which Woolworths has previously said lost $169m in the year, is the obvious blot on the O’Brien copybook.

While Woolworths says the rationale for entering the market remains strong, it has slowed the rollout, is changing the product mix (again) and has abandoned its conviction that the business can break even by 2016. The market has its doubts.

The impact of the hardware strategy and the losses it is generating can be seen in Woolworths' earnings and returns of funds employed in the past two years.

Despite the powerhouse performance of its core operations, Woolworths as a group generated a 4.1 per cent increase in earnings before significant items .

Its return on funds employed in 2012-13 was 28 per cent and in the year just ended 27 per cent. If the losses in hardware could be excluded, the return in 2012-13 would have been 32.4 per cent and 33 per cent in 2013-14. There’s a real price being paid for the attempt to create the new business and take on Wesfarmers’ phenomenal Bunnings business.

The other problem child in O’Brien’s portfolio is the Big W discount department store brand, where EBIT continues to fall. In the latest financial year it was 20.1 per cent (18.8 per cent on a normalised basis) lower at $152.9m.

The problems Big W has experienced in recent years aren’t peculiar to it. Almost every business exposed to the sector (other than Kmart, which has been a contributing factor) has been hit by a very difficult environment marked by intense competition and promotional activity and relatively weak consumer discretionary spending. Target, for instance, has been completely destabilised.

As at Target, O’Brien has introduced new leadership with international experience, with Alistair McGeorge the latest to try his hand at creating a strategy to stabilise and then return the business to growth.

Woolworths’ hotel business continues to produce steady (albeit not spectacular) growth with a normalised 6.5 per cent increase in EBIT to $275.4m.

In an echo of the original productivity plan driven relentlessly by former CEO Roger Corbett in the early 2000s, O'Brien has embarked on a new phase of supply chain productivity improvement dubbed ‘’Mercury II’’ in deference to the success of the original Corbett transformation, which dramatically increased the group’s profitability and lead over archrival Coles.

The new program aims to leverage the masses of customer data Woolworths has accumulated through its Everyday Rewards program to reshape the supply chain in response to the data and the rapid growth of online purchases. 

O’Brien is seeking competitive advantage, again, from a differentiated strategy built on both increased productivity and awareness of its consumers’ behaviours.

A key to O’Brien’s approach since taking the helm has been to try to increase the "stickiness" of customers who historically haven’t been particularly loyal to a supermarket brand. That approach has been a significant factor in the re-booting of the business’ momentum, but Mercury II could add another, structural dimension to the strategy.