Woolies' early warning

Woolworths is Australia’s best-performing major local industrial stock. It seems that to share analysts every day Woolworths tackles Coles and every day it wins and its return on funds increases. In the past five years, Woolworths’ return on funds has risen a whopping 50% while Coles’ return has fallen.

The market believes Woolworths can keep going at this pace, and the stock is priced with no room for anything serious to go wrong. The analysts expect Woolworths to lift earnings per share from the 108¢ achieved in 2006-07 to about 128¢ in 2007-08; 140¢-plus in 2008-09 and 155¢ 2009-10. That is an increase of 34% over three years.

On Woolworths’ past record, it should be able to achieve these analyst targets and probably beat them because the company continues to invest in new stores and new ways to extract money from customers. But at about $28 a share (Woolworths has fallen from above $35 six months ago) it is still priced at 22 times expected earnings in the current year. Australian stocks that are given this sort of rating have a history of stumbling and the trick is to pick an early warning sign.

It’s difficult to find any early warning signs in the Woolworths accounts but this month chief executive Michael Luscombe appeared before ACCC chairman Graeme Samuel and his team. It is never an easy for a chief executive to handle close questioning by a group like the ACCC, so a lot of preparation is required. Luscombe did not do that preparation and was ambushed. He had great difficulty explaining how Woolworths set prices in Australia and New Zealand, and did not explain well the relationship between house brands and top-selling national brands. He admitted that Woolworths was basically matching its rivals’ prices.

I have no doubt that in later, confidential submissions, Woolworths will explain any of the gaps that emerged in the public evidence. But all those who have read the transcript or were at the hearings would have concluded that the Luscombe was in danger of becoming complacent. And you could excuse complacency given Woolworths’ record; it’s just that the market has not priced it in. Material presented to the ACCC showed Woolworths return on funds employed rose from 51.2% in 2001-02 to 76% over the following five years. In the same period, Coles’ return on funds declined and is now about 30%.

There was enormous debate over whether this represented a fair measure given that funds employed are based on historical accounting; are reduced by the fact that both Woolworths and Coles receive money from customers before they pay suppliers; and a large amount of money is invested in the overall business by the owners of the real estate and equipment who lease their assets to Coles and Woolworths. But there is no doubt Woolworths performed as well if not better than any other global retailer and, even Coles, for all its sins also does well on a global rating basis. It is likely the ACCC will take action to at least make it just a little tougher for Woolworths, but I’d be surprised if Graeme Samuel really affects their base business.

What Woolworths’ shareholders need to be concerned about is not the ACCC but the fact that when it came to the Coles presentation to the ACCC, operations manager Mick McMahon had clearly done his homework. He presented much better than Luscombe. Now in the new Wesfarmers structure McMahon has been moved sideways to be in charge of the supply chain and he will be replaced as operating officer by Stuart Machin, who was a senior executive with Asda Wal-Mart in the United Kingdom. Both will report to new Coles managing director Ian McLeod, who reports to Wesfarmers chief executive Richard Goyder. If Wesfarmers can keep that group together and they can work as a team (it might not be easy) they are going to be a very different opponent to anything Woolworths has seen before.

It is likely that Coles will recover some of the lost ground. But even if it doesn’t, it is highly unlikely that Woolworths will gain any further ground. And history will record that Woolworths lost an enormous opportunity over the last three years. Some of the great retail jewels such as Myer, Target, K mart and Officeworks were for sale and Woolworths missed all of them, partly because it was not allowed to buy the Coles supermarket chain that was attached to them. But an ingenious and aggressive Woolworths would have found a way. Instead, Wesfarmers has bought the lot at an attractive price. That means that Woolworths must achieve the growth that the market expects from new stores and more spending from its existing customer base. The company is planning a so-called everyday rewards program, including a company credit card to clearly capture a bigger share of their customers’ wallet. That program had better succeed.

Of course running a public company is very different to appearing before an investigatory body like the ACCC. But it is strange how when a company slips in one area, albeit not vital to its business, it can also slip in more important areas. Wesfarmers has now thankfully raised equity capital and no longer carries the debt risk that came with too much use of short-term borrowings. It is also finally about to put the team in place to run Coles – again, an event that has taken too long. The institutional shareholders can see the upside in the stock, but Wesfarmers private share holders, including those that have come across from Coles, are nervous.

Part of the problem is that Wesfarmers is not looking at a quick turnaround and has already had control of Coles for seven months. Second, when you buy Wesfarmers shares you are also buying coal assets, which are currently booming but could become a problem if the world turns against carbon in a meaningful way. Retail and coal tend to attract different investors apart from those using the two assets as apart of a balanced portfolio. Nevertheless, the upside for Coles is clearly enormous because there is no way Woolworths should be able to earn 150% more on funds employed than Coles, particularly as most of the difference has been established in the past five years.

The most difficult task Wesfarmers faces is to rid Coles of the deep-seated bad practices that keep emerging. In addition, too many in the Coles company think that they are doing well even though they are way behind Woolworths in return on funds. In other words, they are really not competing. These are two of the big cultural shifts that are required.

But, if Woolworths becomes complacent and Coles begins to substantially lift its game, then the sort of growth rates that the market is expecting from Woolworths won’t be achieved. Woolworths is a fantastic business and will remain a fantastic business, but the problems of Coles have caused the sharemarket to assume Woolworths can continue its amazing performance of the past five years into the next five. As we have seen in many other instances, if anything goes wrong, the sharemarket treats the highly rated stocks very harshly. Let’s hope that Woolworths can keep up the pace but if it doesn’t, be aware that the ACCC encounter was the early warning sign.