We need to talk about Woolworths

Woolworths is an iconic Australian business that has rewarded shareholders consistently over many years. The company has an industry leading market share and has consistently generated returns above both its cost of capital as well as most other listed companies in Australia. It is a ‘blue chip' stock that most likely resides in many portfolios.

In the past 12 months, however, WOW's share price has declined by 25 per cent against a rising market and is now trading on a 15 times price-earnings multiple, below its long run average of 17 times.

The question has to be asked as to whether it is time to consider buying WOW shares.

While arguably screening as cheap, it appears that a number of risks and uncertainties exist in the investment case for WOW and, in our view, the current share price does not provide a sufficient margin for error to warrant investing.

Woolworths has a long and illustrious history of improving profitability in its key food and liquor (F&L) division and delivering shareholder returns. However, the company has three strikes against it now

Strike #1: Margins are going to decline

The real challenge facing Woolworths is increasing low cost competition in its grocery division, particularly from Aldi.

Rather than going through the business model of discount supermarket Aldi, we will simply say that they have arrived, are highly price competitive and since entering Australia in 2001, have gained around a 10 per cent share of the grocery market.

Is this really a big deal? Well, in FY14 WOW's food and liquor division generated an earnings before interest and tax (EBIT) margin of 8 per cent. This is materially higher than Coles at 5.3 per cent and roughly doubles that of many of its global peers.

With Aldi continuing to pick up share and Coles getting traction in its own turnaround, WOW does need to consider how it will respond to the changing industry dynamics. At its recent investor day WOW discussed a $500m ‘investment' in delivering lower prices to consumers, having already delivered $125m of price cuts since in 2015.

Clearly, an ‘investment in', or perhaps put more clearly, a lowering of prices, will result in a lowering of divisional margins if it isn't offset by increases in market share or better buying outcomes.

To put some context around a potential outcome, a reduction in WOW's food and liquor division EBIT margin from 8 per cent to 6 per cent, other things being held constant (market share, addressable market size, etc.) would result in a 21 per cent reduction of group operating profit. This would still leave WOW with higher profitability than both Coles and global peers.

Where margins and market share shake out over the medium term is clearly difficult to forecast. However, the risks to both metrics certainly appear to be skewed to the downside.

Strike #2: Masters

Woolworths' non-food and liquor retailing has raised a number of red flags around management's ability to allocate capital and execute strategies outside of their traditional core business. This does raise the question as to whether management change is afoot.

In 2009, WOW entered into a joint venture with Lowe's to enter the home hardware market in Australia. WOW ownership of the JV is 66 per cent, while Lowe's retains the balance with an option to sell their share back to WOW.

As it stands today, in excess of $3bn has been invested in the venture.

For this $3bn investment, WOW's home improvement division reported a loss of $176m in FY14. Recently, Lowes reported a $US17m loss for the three months to May 1 for their share in the business. This equates to AUD $66m for the total business. As a result, in FY15 losses look set to be in excess to $200m and things do not appear to be improving.

Six years down the path of WOW's venture into the home improvement market things certainly appear challenged. WOW management has now decided to reduce the capital allocated to Masters by $600m and reduce the store roll out program by 4-10 per annum (versus 15 per annum previously). This capital will be redirected to investing in the food and liquor business. In any case, a reduction in capital allocated to this business certainly isn't a vote of confidence in the strategy.

Not only is the venture struggling but Lowe's has a put option to sell its 33 per cent stake in Masters to WOW. From October 2015, Lowe's can issue a notice setting an exercise date triggering a 13 months notice period after which the option can be exercised. At June 30, 2014, WOW carried a financial liability on its balance sheet of $771.2m reflecting the potential cost of this put option being exercised.

So as it stands today WOW has sunk a significant amount of capital into their home improvement business, and may need to contribute much more while the business continues to struggle. It certainly appears as if this division will continue to be a challenge to management for some time. 

Strike #3: Dick Smith

We have written at length about DSH this year and Alan Kohler interviewed Nick Abboud, DSH's chief executive, last week. The fact that current management have been able to turn around DSH's fortunes so rapidly after coming out of WOW ownerships really does raise some questions regarding WOW management.

By way of background, Woolworths acquired a 60 per cent stake in the DSH in 1980. Shortly thereafter, in 1982, Dick sold his residual stake to Woolworths, giving the company full ownership.

Woolworths expanded the business over the following 30 years and in 2009 had in excess of 430 stores generating over $1.5bn of revenue. In FY07, under Woolworth's stewardship, Dick Smith generated earnings before interest, tax, depreciation and amortisation (EBITDA) of $95.5m.

After that, however, the business began to struggle. In 2012, Woolworths restructured the business, taking $420m of impairments and related charges and subsequently sold the business to private equity firm Anchorage Capital for $20m.

At the time, DSH's cost of doing business (CODB) was around 24 per cent of sales which was materially higher than JB Hi-Fi which was operating a largely comparable business with a CODB of 16 per cent of sales.

Under new ownership and management, DSH undertook a rapid transformation program. This primarily focused on a review and the restructuring of corporate costs, its supply chain, procurement initiatives and aggressive rebranding. These are simple changes and the benefits are clearly visible in reported earnings today.

The Anchorage deal gave Woolworths 25 per cent participation of any profit on sale of Dick Smith. Anchorage subsequently paid $74m to Woolworths to remove this option as the turnaround was getting traction. In 2013, Anchorage floated Dick Smith at an issue price of $2.20 per share, or $520m – an incredible profit on a $94m investment in anyone's language and an embarrassment for the WOW management team and board.

Why would you step up and invest at the moment?

If, for a number of consecutive quarters, WOW generates a relative improvement in its F&L sales growth relative to Coles then the case can be made that sentiment will improve and the share price will re-rate.

To risk your capital on this investment thesis you would need to have some particular insight or at least be confident that this is going to happen.

Furthermore, for the re-rate to occur the market would need to discount the additional risks facing the business.

While this may happen, we have no particular insight to be confident that it will.

Why would you wait to see how things play out?

There are a number of uncertainties relating to the investment case for Woolworths as it stands today. We outline some of these below:

• The impact on low cost competition on WOW food and liquor division margins. Aldi and Coles, and to a lesser extent on line competitors (such as Kogan, Vinomofo etc) are here to stay and intent on aggressively competing on price. With the F&L division accounting for 80 per cent of group profitability, this is the key issue and key challenge facing the business.
• The outcome of the Masters saga. Will Lowes put their 33 per cent interest to WOW? Will store profitability turn positive in the medium term future? Will management choose to limit their losses and exit the sector?
• The potential for management and board change. With a number of questionable execution and capital allocation decisions made in recent years it would seem that management or board change or both is possible if things don't improve in the near to medium term. What this would mean for future strategy is anyone's guess. 

There is no doubt that Woolworths has phenomenal industry positioning and strong ability to generate returns in its key food and liquor division. However, it appears that a number of risks and uncertainties exist in the investment case for WOW.

In our view, despite the recent sell off, the current share price does not provide a sufficient margin for error to warrant investing.