Woolworths' almost wonderful world

Bar hardware, Grant O'Brien's tinkering has swung Woolworths to a decisively better place, with earnings growing, return on funds improving, expansion costs peaking and online flowing.

About two years ago, when Grant O’Brien outlined his strategic vision for Woolworths, it was neither bold nor radical, but rather a broad series of modest tweaks to businesses that had lost their competitive edge rather than their way. If the teething pains from Woolworths’ costly excursion into hardware could be excluded, he’d be very comfortable that the group is on track to deliver what he promised.

Woolworths, of course, didn’t need radical change. Its model wasn’t broken but it was struggling to respond to the turnaround in its major competitor’s performance as Coles, after a decade or more of dwindling relevance, rebounded under its Wesfarmers-appointed management (Shopping bags the bucks for WesfarmersAugust 15). Woolworths had become reactive and its momentum was slowing.

With a sales base approaching $40 billion (it actually passed $40 billion in the latest financial year), of course minor improvements translate to big bottom line gains and it has been the series of small changes O’Brien and his team have implemented that have produced increasingly solid gains.

Excluding significant items and adjusted for the extra week of trading in 2012-13 Woolworths lifted earnings 6.1 per cent to $2.36 billion. At an earnings before interest and tax level, excluding the hardware businesses and their $138.9 million of losses, earnings (normalised for the additional week) were up a very respectable 8.1 per cent.

Woolworths’ return on funds employed – excluding significant items and property development, which had fallen from 32 per cent in 2008-09 to 28 per cent in 2011-12 – has stabilised and is now trending up.

If the Masters’ hardware business is excluded the underlying return on funds was 31 per cent and if both Masters and property developments were excluded it would be 36 per cent against the 34 per cent return on the same basis in 2008-09.

Stabilising and then lifting Woolworths’ returns on capital is seen as a key to judging O’Brien’s tenure, with the group’s critics arguing that it has been too focused on ploughing capital into expanding its footprint and aggregate sales base than on those returns and the interests of shareholders.

It does have the ability to recycle more of its developments off its balance sheet into the SCA Property Group it established and listed during the year, which should help tweak returns.

While it would appear that Woolworths has stabilised the returns from its core businesses the jury is still out, and will be out for some years, on the question of whether the billions that will be committed to the hardware business by Woolworths and its joint venture partner, Lowe’s, will ever generate acceptable returns (see Woolworths finds itself in a hardware quagmire, July 18 and The competency question falls over WoolworthsJuly 19).

It isn’t off to a good start in the face of fierce competition from the established incumbent, Bunnings, and after a series of self-confessed mistakes and overly-optimistic assumptions by Woolworths and Lowe’s as they tried to come to grips with the category.

The core of Woolworths is its Australian food, liquor and petrol business and, on a normalised 3.9 per cent increase in sales, it produced a 6.7 per cent increase in EBIT, to $3.2 billion. It improved both its gross margin (by 30 basis points, to 25.1 per cent) and its return on funds (by 294 basis points to 76.7 per cent) on the back of better buying, less shrinkage and lower costs of doing business generally.

O’Brien has devoted a lot of attention and money to improving Woolworths' insights into its customers and leveraging its Everyday Rewards loyalty program and its seven million-plus members to improve customer loyalty and basket sizes, and those investments appear to be paying off along with the massive investment in refurbishing and expanding the store network. Customer numbers per week increased 3.6 per cent to an average of 28.4 million, and the division’s second-half sales growth was ahead of the first half.

Woolworths’ capital expenditure increased $318 million in the year, to $2.35 billion, as it spent $300 million on new stores (excluding hardware), $268 million on refurbishments and $343 million on new developments. It opened 34 new supermarkets during the year.

The expansion of the supermarket network peaked in the last financial year and the investment in it will decline by about $50 million this year, although Woolworths still expects to invest $2.35 billion in 2013-14 including $560 million on the Masters’ rollout.

O’Brien has also prioritised what’s rapidly becoming a successful multi-channel strategy.

Woolworths’ online sales in the food and liquor businesses grew 50 per cent in the year and overall the group’s online sales were up 42 per cent. It is forecasting more than $1 billion of online sales this financial year, so that strategy too, is developing momentum.

The other established business that needed attention when O’Brien became chief executive was Big W which, in common with other discount department stores groups, had been struggling in a recessed retail environment and the impact of the resurgent Kmart as Guy Russo developed his very disruptive narrow-range, high-volume and low-prices model.

Big W increased its EBIT 7.2 per cent on normalised sales growth of only 2 per cent, with a 102 basis point increase in gross margin and a 9 basis point improvement in its EBIT margin to 4.36 per cent. Its return on funds slid slightly, from 20.8 per cent to 20.2 per cent. Again there was no ’Big Bang’ shift in retail strategy but a lot of fine-tuning of costs and the retail offer.

Strong results from the hotels business, aided by continuing acquisitions and a solid result from Woolworths’ New Zealand supermarkets rounded out what was, excluding the hardware business, a very respectable across-the-board performance.

O’Brien was cautious about the outlook for this financial year, saying the group expected conditions to remain subdued and consumers to remain cautious. He provided modest guidance of a 4-7 per cent increase in earnings from continuing operations, with Master’s losses not expected to exceed those incurred in 2012-13.

The hope for all retailers, after the unusual and unsettling experience of a minority government and what has effectively been more than a seven-month and torrid election campaign, is that consumer confidence and spending will improve after the federal election.

The apparent improvements in the basics of Woolworths core businesses means that any pick-up in spending levels ought to have something of a leveraged impact on its earnings, although the same could be said of most of the bigger retailers given that they’ve all be forced to adjust to the recessed retail environment of the past few years.