Woolworths: Result 2014

Despite having the smallest range of products, Aldi recently topped a Canstar Blue survey as Australia’s best supermarket. It was the only one to achieve five stars for overall satisfaction and value for money, though it also scored five stars for product quality, store layout, deals and specials and the freshness of its food.

It was a kick in the teeth for Woolworths, which only scored five stars for its wide array of products and store layout and a measly three stars for value for money, which the company prides itself on. Fortunately the survey also found one in every two shoppers is loyal to one chain due to convenience and familiarity, which explains why the company’s food and liquor business is the best we’ve seen.

Despite prices falling over 3% on average, the division’s sales increased 4.7% to $41bn. Operating profit increased much quicker at 7.1%, showing the company hasn’t lost its ability to grow profits faster than sales despite increased competition from Coles, Aldi and Costco.

Mixed bunch

While management has a few levers to pull in the food and liquor business other divisions are more problematic. The hotel business is mature, capital intensive, subject to unfavourable regulatory changes and, despite operating profit growing a healthy 4.4% to $275m, it only constitutes 7% of Woolworths’ total operating profit. It’s an ok business, but it won’t move the needle for Woolworths’ profits like its grocery business can.

The New Zealand supermarkets division is around the same size but its return on funds employed is only 9.9%, compared to 75.7% for the Australian business. Woolworths has been trying for years to turn a decent profit in New Zealand, but it doesn’t seem to have the scale and chief executive Grant O’Brien should consider selling it given it should currently fetch a high price.

Sunken ship?

Ditto for Big W, which suffered a 19% drop in operating profit to $153m. Rival K-Mart (owned by Wesfarmers) has been dropping prices and contributing to the general malaise in the discount retail category. Target (also owned by Wesfarmers) has been upended as well, suggesting it’s not necessarily bad management but rather intense competition that’s permanently reduced returns in the sector.

If we were in charge we’d test the appetite for a float while IPOs were in vogue. Private equity investors might be keen too if they also believe rolling out new stores is the way to go, as we’d expect Woolworths to have done a half decent job with the supply chain and other efficiencies given its success with the food and liquor business.

Instead, O’Brien has followed the trend amongst Australia’s large retailers by hiring British retail industry veteran Alistair McGeorge to right the ship. Big W isn’t a basket case like Target just yet, but it wouldn’t surprise us if O’Brien looks back in years to come and regrets investing heavily in the business.

Masters

Having recently updated the lousy short-term outlook for the Masters hardware franchise in Woolies still learning with Masters on 13 Aug 14 (Buy – $35.74), you can clearly see why Woolworths remains on our Buy list. Despite intense competition the food and liquor division continues to confound the sceptics by growing nicely under O’Brien’s leadership, setting the scene for higher dividends over time. Woolies’ other businesses pale against what is arguably Australia’s best business.

O’Brien has laid out a clear plan for the company, including beefing up the ability to serve customers online, analysing more customer data to prevent customers from switching to a rival offering and redoubling efforts to cut costs in the supply chain in order to pass on more savings to customers. It’s not rocket science, but with competition and howls for quick fixes intensifying it isn’t easy.

As we don’t expect Woolworths’ current price-to-earnings ratio of 18 to increase given its maturity, we’d be happy with a 9% total return or slightly less. That’s roughly 4-5% earnings growth combined with the current fully franked yield of 3.8%, which seems fair for such a mature, reliable business in a low interest rate environment.

O’Brien has done an admirable job since taking over in 2011 and he’s focused on the right things. Though we’re on the cusp of downgrading Woolworths, the stock remains suitable for conservative investors with modest expectations. BUY.

Note: Our model Growth and Income portfolios own shares in Woolworths, and look out for part two of Supermarket superwars next week.