Woolworths: Result 2015

If Woolworths' transformation program was a clock that started at 12 midday then, by our estimate, it's now approaching 1pm. Midnight is an age away and it's barely even lunch time. The analogy is apposite because, with Woolworths' same-store sales falling 0.9% in the fourth quarter of 2015, Coles and Aldi are eating its lunch.

Management revealed on the 2015 results conference call that same-store sales were still falling in the first eight weeks of 2016. You should believe them when they tell you that this is a three-year journey. The company's problems will take time to fix.

On the face of it, the 2015 result didn't look so bad. Sales and profit were flat – see Table 1 – while the final dividend was maintained at a fully franked 72 cents. Somewhat mystifyingly, the share price even rose. So what's the problem?

For a low-margin retailer, falling sales are poison. To see the problem emerging in the company's Food and Liquor division – its most important by far – you only need look at the result from the struggling Big W, where the transformation 'clock' is perhaps late afternoon. There 2015 sales fell only 6% but earnings before interest and tax (EBIT) slumped 25%. This is what 'operating leverage' looks like – profits get crunched when sales fall even slightly.

It's why Woolworths is rapidly trying to regain price leadership. With customers now perceiving that competitors are cheaper, it is lowering prices fast. Woolworths reported price deflation of 5.2% in the fourth quarter and now claims its prices are at parity with Coles. Online, they're cheaper.

Woolworths can't afford to frustrate tetchy customers with long checkout queues and poor stock availability at this point either. So it's also reinvesting in service levels, with more staff in-store.

The problem will be convincing customers to return. Once lost, they're harder to lure back. Other problems – such as poor customer perceptions towards its Home brand range – will take longer to fix.

None of this is retail rocket science. Indeed, it's retail 101. Unfortunately the changes will come too late to prevent a significant fall in margins. Indeed, that's what's required, as we argued in What's Woolworths worth? – Part 2 from 10 Dec 14 (Under Review – $29.88). Woolworths isn't providing guidance for 2016 but the following statement from its results presentation tells you everything you need to know: 'Investments in price, service and experience will exceed cost reductions in FY16'.

Falling margins

In other words, lower prices and higher costs will mean falling margins and reduced profits. Woolworths' profitability peaked in 2015 and it's downhill from here, at least for a year or two.

The risks are compounded by management change. The 2015 results conference call was odd because three of the management team won't be with the company by year-end. Chief executive Grant O'Brien fell on his sword in June (although he presented the results today). Soon-to-depart Penny Winn stepped in to present Big W's result after that division's head resigned recently. And today chairman Ralph Waters announced he would soon be replaced by Gordon Cairns. The company's revolving door must be getting a workout.

Brad Banducci, the recently appointed head of Food and Liquor, comes with an impressive pedigree but is new to the job. His intention is to roll out 80 new format stores this year but it's not clear exactly what the new format will be. What is clear is that Woolworths has been sweating its assets for too long. Banducci aims to reduce the average age of the store network from above 9 years to 7 years over time.

To add to the management uncertainty, O'Brien's replacement – whoever it is – could arrive and shake everything up once again. With the clock ticking, how might the rest of this year unfold?

First, Woolworths needs to appoint that new chief executive. There's not even a shortlist just yet but Gordon Cairns will be sharpening his interviewing skills. Second, by the annual meeting in November a clearer picture of the damage to this year's margins should emerge.

Third, the new chief executive will inevitably conduct a strategic review, with the findings unlikely to be announced before the company's interim results in February 2016 (at the earliest). And fourth, the review will probably be implemented commencing in the second half of 2016.

The implementation of the strategic review is when Food and Liquor margins might lurch downwards again. The new chief executive will want to secure Woolworths' market leadership, and he might flag the sale or closure of Masters at this point too.

Masters loss

While Masters incurred a $246m loss in 2015, the new chief executive won't let it bleed money for long. While writedowns are likely, the $2.8bn of capital deployed in the Home Improvement business is a sunk cost. So don't worry about Masters unduly; it's the Food and Liquor division that matters from here.

After re-running our numbers assuming a 5% margin in Food & Liquor, the closure of Masters and a minor turnaround in Big W, we arrive at possible earnings per share (EPS) of around $1.40 (compared with the $1.95 figure just reported). Whilst not a worst case, it provides support to our $25 Buy price (as the price-earnings ratio should expand as earnings come down).

Investors are already assuming earnings will fall in 2016 and beyond; consensus estimates are currently for EPS of $1.74 in 2017. Our suspicion is that earnings might fall lower than this but it will take time.

There may be multiple opportunities to buy Woolworths over the next year or two, as we've said previously. Perhaps actual evidence of earnings declines rather than today's Delphic pronouncements from outgoing management will prove to be the catalyst.

For now the stock has bounced higher and sits 4% higher than Crunch time for Woolworths from 18 Jun 15 (Hold – $26.33). The clock is certainly ticking, but patience will hopefully be rewarded. HOLD.

Note: Our Income Portfolio owns shares in Woolworths.