Did you know that more than 10m customers shopped at a Woolworths store last month? They did so because it was convenient and they wanted items they couldn’t get from Aldi. The customer is always right, they say, and in this case plenty of them continue to shop at Australia’s largest supermarket chain.
Grocery market to remain a duopoly
Early progress being made to fix problems
News likely to be less negative from 2017 year
Of course, the business has a few warts, as we explained in Part 1. Margins will never regain their 2015 peak; indeed, they might fall more in the short term. Aldi’s Australian sales are only going to increase from here. Competition from Lidl and Amazon Fresh looms on the horizon.
Fixing the problems – something we’ll get to a little later – will entail lower margins. Our base case, as discussed in Part 1, relies on the Australian food and liquor margin (excluding petrol) being around 5% in 2019. That’s lower than we expect for the 2016 financial year.
But it’s still higher than some other countries, for a very simple reason. The Australian grocery market is – and is likely to remain – more concentrated and less competitive than elsewhere.
Despite market share losses, Woolworths and Coles still dominate the supermarket sector with a massive 70% share, as you can see from Chart 1. Few other markets in the world are as concentrated as Australia's. In the UK, US and China respectively, the top two supermarket groups control 44%, 42% and 21% of their markets respectively. The smaller players also tend to be larger than here.
Market concentration tends to be higher in smaller countries. The top two grocery chains in Canada have 51% market share for example, while in New Zealand it’s 100%. In smaller countries, size and market dominance tend to allow higher margins.
Woolworths and Coles are entrenched. Whatever new competition arrives, they will remain the two largest players by far. Even Aldi executives admit it’s difficult for discount supermarkets to exceed a 20% market share (Aldi’s currently at 12% locally).
Returning to Chart 1, what happened to Woolworths’ Australia food and liquor sales over the period its market share declined from 40.9% to 37.3%? Perhaps surprisingly, sales rose 52% to $42bn. There’s natural growth in the grocery market, so modest share losses to Aldi or anyone else aren’t going to kill Woolworths – or Coles for that matter.
Therein lies another erroneous assumption – that Aldi’s low prices are Woolworths’ main problem. Aldi is of course influencing prices but, if low prices were all that mattered to customers, Aldi would be hurting Coles too. In fact, Coles’ margins have increased and same-store sales growth has been decent enough over the past five years (see Chart 2). Indeed, it’s the resurgence of Coles that has been the most significant issue for Woolworths.
So, while the Australian grocery market has become more competitive – and could become yet more so – it’s unlikely to become as cutthroat as the US or UK. Woolworths has made a mess in aisles one, two and three, but it’s nothing a decent mop and bucket can’t fix.
A surprising amount has been mopped up already. The company has a new chairman, board and managing directors for the group as well as Big W. Masters has also been dealt with.
Managing director Brad Banducci has already taken steps to fix price perceptions compared to Coles, for that is what matters most. The retailer has invested more than $500m in prices and it is making a difference. Service is another focus – rostering has been improved so there are more staff available on busy days like Sunday. When you’re a full-line supermarket like Woolworths, it’s imperative that you provide better in-store service than your discount competitors.
Other issues will take much longer to fix, including store refurbishments. Woolworths is in the early stages of testing out new store concepts, including rolling out smaller convenience-type stores in metropolitan locations.
We recently visited the new full-line Mascot store shortly after opening and it was a step up from your average Woolworths supermarket. In truth the Mascot store wasn’t that much different from Coles’ revolutionary new format in 2009. It doesn’t need to be though – after sweating its assets for too long, Woolworths just needs to bring its stores into the 21st century.
Fixing its fresh and packaged grocery offers will also take time. Somehow Woolworths has let Coles become ‘the fresh food people’, which has damaged its brand. Woolworths has also dumped its Homebrand and Select private label brands in an attempt to reposition them (Coles did the same thing with ‘You’ll love Coles’ and ‘George J Coles’ after the Wesfarmers takeover).
Banducci gets that both names and incentives matter. The ‘head office’ at Bella Vista in Sydney is now a ‘support centre’ for Woolworths stores and all staff are required to spend time in-store. Banducci has also relaunched the management incentive scheme, focusing on things like sales growth, profit, ‘voice of the customer’ (which measures customer satisfaction) and stock losses. Cultural issues and staff turnover take time to fix but Banducci understands their importance.
It’s easy to forget that 2016 has been Woolworths’ ‘annus horribilis’, a full 24 years after the Queen experienced hers. Enormous changes and additional costs have dominated the year; some will persist into 2017 but others won’t. Same-store sales growth has been negative but that will make it mathematically easier to achieve growth next year. Other important issues, like the out-of-stocks caused by the implementation of new IT systems, should be resolved in 2017 too.
Also easy to forget is what Woolworths is still doing right. It has the best liquor business by far, the best online grocery offer, and a well-respected property team that has relationships with developers to secure the best sites.
We’re under no illusion that Woolworths’ turnaround will be fast (Coles’ own turnaround took more than five years and remains incomplete). Coles may respond with its own price cuts, although the risk of an all-out price war is low. And Aldi will take market share in South Australia and Western Australia over the next few years (keeping it in perspective, a maximum of $2.4bn of sales out of a $100bn national grocery market by 2020). The risks of Woolworths’ turnaround – and the stock’s mild undervaluation – are why we’ve recommended only a 2–3% initial portfolio limit thus far.
Nevertheless, we’re getting closer to a more emphatic Buy and an increase in that weighting. Further disappointment – and another fall in the share price – could come via a weak 2016 result, a capital raising, a strategic review that underwhelms the market, or a higher-than-expected final dividend cut.
For what it’s worth, we now think market expectations of 125-130 cents in earnings per share for 2016 are probably a little high. On an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) basis, the stock continues to look reasonably priced at about 8.5 times.
With the share price down 15% since our initial upgrade in Woolworths takes tough decisions, our long-term return expectations are now higher. Ten million customers shopped at Woolworths last month, and ten million will shop there this month too. If they haven’t already started noticing the changes the retailer is making, they soon will. BUY.