Woolworths heads back into the ring

Former Woolworths (ASX: WOW) supermarkets head Bill Wavish has criticised current management but endorses the return to its former double loop strategy. 

There’s a ‘dogs-passing-lamposts’ quality to former employees critiquing their replacements, each wanting to rain on the parade of their successors, especially if they’ve been fired or moved on after losing an internal power struggle.

Psychologists call it self-attribution or self-serving bias, in this case expressed in the tendency for managers to take credit for the good things that happen under their watch but blame their replacement for any subsequent poor performance.

The psychological rationale is to protect the ego – and let us acknowledge that most corporate senior managers do not suffer from a lack of self-confidence - from threat and injury.

Nevertheless, recent criticism by former Woolworths (ASX: WOW) executive Bill Wavish rings true.

Wavish was head of supermarkets under Roger Corbett’s reign when the company generated fantastic returns for shareholders. Investors enjoyed a more than four-fold rise in Woolworths’ share price from 2000 to 2009, as well as steadily increasing dividends – by pursuing what became known as the ‘double loop’ strategy.

The most complex thing about it was the name. In plain English, Woolworths simply passed the cost savings and efficiencies it made through improved purchasing, supply chain management, staffing and so on, back to customers through lower prices.

That drove volumes, sales and profit growth, most of which was then reinvested in lower prices, at which point the process started over. It was a simple but highly effective approach that beat Coles into the ground.

In Wavish’s opinion, the company’s current difficulties can be put down to it ditching the ‘double loop’ strategy after he departed.

It’s true that Wavish hasn’t been involved in the company for many years, as Woolworths was at pains to note. Corbett and Wavish also benefitted from a weaker Coles (before its recent purchase and reinvigoration by Wesfarmers (ASX: WES)) and a market place not yet fully exploited by low-cost competitor Aldi.  

However, Woolworths’ protestations that it has already invested hundreds of millions in lower prices in recent years conflict with the general perception that it’s expensive. Woolworths still enjoys industry-leading grocery EBIT margins (which have steadily increased in recent years) but on quarterly comparable store sales growth, Coles has beaten Woolworths’ over most of the past five years.

This supports the Wavish view. Woolworths has chosen margin over volume, opening the door to Aldi and a reinvigorated Coles to compete on lower prices. Now Woolworths finds itself in the odd position of returning to a strategy it pioneered in order to better compete with a company that copied it.

There are two lessons in this. First, even the best businesses can come unstuck if management changes strategy or gets distracted by other ventures, as could be argued Woolworths has become with its Masters joint venture.

Investors have a tendency to focus on the attractive traits of management and over-estimate their impact on the company, a bias known as the halo effect. Strategy and implementation usually has a far greater bearing on company profitability than the perceived personal qualities of those running the show.

Second, carefully examine the incentives driving management’s compensation. If short term incentives (STIs) represent a large proportion of potential management remuneration, this can send a message to managers to prioritise short-term gains over long-term goals. 

In the case of Woolies, there’s no way of knowing if remuneration incentives influenced management behavior. But the annual report reveals that in 2012 and 2013 half of total possible CEO remuneration was allocated to short term incentives (STIs) and only 17% to long term incentives (LTIs). That may have made a quicker return to the double loop strategy harder.

Last year, the board made reinvesting profit into lower prices more likely by sensibly shifting the emphasis back towards LTIs, which now account for 40% of total possible CEO remuneration (STIs are now just 30%). In the meantime, the company has lost a good few years.

As to Woolworths’ future, we agree with its return to the ‘double loop’ strategy. It’s good to see Woolies back in the ring, fighting for customers instead of merely enjoying its high margin position at the expense of its long term health.

But as senior analyst James Carlisle notes, the real question for investors is how far margins will have to fall to allow it to reassert its dominance over Coles, Aldi and Metcash (ASX: MTS). And that remains to be seen.

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