Lessons in Tesco travails for Woolworths?

It's not every day you see a 16% slump in the share price of a supermarket group. Food retailing is meant to be one the most defensive businesses; less prone to Mr Market's moods, or so it seemed.

So the downdraught in the price of UK supermarket group Tesco following a profit warning last Thursday must have rattled some nerves. Tesco is the UK's largest supermarket chain, with a market share of around 30%. It has the highest margins of all its competitors and has long been regarded as well-managed. Warren Buffett's Berkshire Hathaway owns 3.6% of Tesco's stock and he is on the record as wanting to buy more (I suspect he's already on the case).

Tesco's profit warning appears to have been caused by the 'Big Price Drop' initiative, a decision to cut product prices across the board, coupled with very poor Christmas trading (vital for any retailer, even supermarkets). While hard to verify, there is also talk that the company has let its service standards, product quality and stock availability slip.

Worrying similarities

As Intelligent Investor's analyst for Woolworths, I'm most concerned with any lessons Tesco's situation might have for the Australian company. There are some potentially worrying similarities:

1. Both Woolworths and Tesco are facing more difficult conditions in their home markets. Woolworths reported its first ever profit downgrade last year.

2. Both Tesco and Woolworths changed chief executive during 2011. While the new appointments are longstanding 'company men', they replaced highly respected predecessors (who, it must be said, benefited from agreeable economic tailwinds).

3. There have been significant departures from senior executive ranks since the change of chief executives. For the first time, Woolworths appointed an outsider to the crucial head of supermarkets role (see Woolies goes Dutch from 25 Nov 11).

4. Competitors have lifted their game significantly in recent years. Coles' management appears to be satisfied with a much lower operating margin than Woolworths, which could spell trouble for the latter.

Changes such as these increase the risk that Woolworths ends up doing something silly. A revitalised competitor and changing consumer behaviour could lead Woolworths' less experienced management team to make some potentially poor business decisions.

Tesco hasn't been mortally wounded by this mis-step, but the profit warning highlights how quickly and easily retailers can make mistakes. Woolworths' margins are already very high, perhaps too high.

Any strategic blunder could see its margins come under pressure. Shareholders would do well to remember that even the best business is never bullet-proof. Allocate capital prudently, but be prepared to act if Mr Market provides an opportunity.