Woolworths' capital concession

Woolworths' decision to buy back $400 million of capital, its first such capital management initiative for six years, suggests both a slight tweaking of Woolworths' remarkable model and, perhaps, some concession to the market.

Most of the Woolworths model still works brilliantly. Its latest half results are consistent with the metrics the group has been generating for years, with sales (excluding petrol) up 6 per cent, which drove an 11 per cent increase in earnings before interest and tax and an 11.4 per cent rise in after-tax earnings.

There were, however, a couple of small blemishes. The group's cost of doing business didn't fall, which is most unusual, and its return on equity slipped from 15.08 per cent to 14.63 per cent. A contributing factor was the tough conditions within its hotels business, where earnings were down 8.4 per cent.

The return on equity issue is one that the market has become more focused on, with Merrill Lynch's David Errington articulating it best, arguing that unless Woolworths reduced its relentless heavy re-investment in its businesses it wouldn't be able to grow its returns on equity. He has said the group is too focused on its customers and competitors at the expense of its shareholders.

Woolworths' DNA wouldn't allow it to be anything other than obsessed with its customers and competitors – it has been the driver of the group's outstanding performances through, initially, Roger Corbett's period as chief executive and now Michael Luscombe's.

Luscombe – one of the few CEOs not to raise equity during the financial crisis – has, however, created an opportunity to do some fine-tuning of his performance statistics and boost the group's ROE and earnings per share with a modest capital reduction.

What was an extremely heavy capital expenditure program as he pumped nearly $1 billion a year into a massive refurbishment of the group's store networks has now peaked.

Indeed Woolworths expects to spend significantly less than it previously expected this year, with its forecast total capital expenditures adjusted from $1.54 billion to $1.28 billion. In each of the preceding two years Woolworths invested about $1.4 billion. The group has cut back on its planned spending on both refurbishments and "normal" capex.

In the context of the size and quality of Woolworths' balance sheet and cash flows the proposed buyback is more of a gesture than a statement.

That may be because Luscombe has a new and heavy wave of investment in front of him as Woolworths gears up for its assault on Bunnings' dominance of the "big box" end of the hardware market.

Woolworths has so far put its foot on 40 of the 150 sites it plans to secure for its new hardware business over the next five years and says it is on track to open its first store in 2011. The various estimates of the overall cost of establishing the new venture (with its junior partner, Lowe's of the US) range from about $3 billion to as much as $5 billion.

There will also be some start-up losses, no doubt, as Woolworths scales up the business.

The ambitious entry into hardware will almost inevitably have some impact on the group's performance statistics until the network reaches some level of maturity.

The group acknowledges that the proposed buyback is modest but says it is a start and that it has balanced the desire to return capital with its need to retain the financial flexibility to invest, pursue growth and retain a strong credit rating. The decision showed, it said, a belief in the strong outlook for the business balanced by continuing uncertainties in global financial markets.

Its description of the buy-back as the "re-commencement" of an ongoing capital management program suggests there is more to come, circumstances and the needs of the business willing.

Apart from the drive into hardware, Woolworths looked at a lot of other opportunities during the crisis, including a very intense scrutinisation of the US supermarket sector.

The decision to launch the buyback and the flagging of more in future suggests that, for the moment at least, its growth focus beyond its existing portfolio is confined to the hardware sector and that, with the cost of the supermarket refurbishment program now falling away, it hopes to be able to finesse the returns to customers and shareholders from the output of the Woolworths model a little more evenly in future than in the recent past.