Was that it? Was 18 months of pain all that Woolworths shareholders had to endure? We’ve maintained that Woolworths’ wounds were largely self-inflicted – and only skin-deep – but have they healed already?
The 4% jump in yesterday’s share price suggests so. In Woolworths – Competition cuts in – Part 2 on 21 Jun 16 (Buy – $21.13) we said that if customers ‘haven’t already started noticing the changes the retailer is making, they soon will’. Our thesis was that investments in price and service would eventually draw customers back into Woolworths’ supermarkets.
Apparently customers are noticing, because the fourth quarter same-store sales decline in supermarkets was the smallest of the year, at -1.1%. With fourth-quarter deflation at -2.7%, partly due to a 10% decline in produce prices, this sales number was better than it looked. The trend was up too, with same-store sales growth for the eight weeks to 21 August of 0.3%. The return to growth we were expecting some time in 2017 seems to have already arrived, albeit in miniature.
Result as expected
Home improvement exit imminent
Lowering Buy price
All this meant the market shrugged off the $4bn of writedowns that took Woolworths to a loss of $1.2bn, its first as a listed company. Removing those – and the effect of the home improvement debacle – Woolworths reported sales of $58.1bn (down 1%), EBIT of $2.56bn (down 35%) and net profit of $1.56bn (down 39%) - see Table 1. These numbers were in line with the guidance given at the time of Woolworths takes a big bath on 25 July 16 (Buy – $24.30).
For the first time, Woolworths split results for its food and petrol business from its liquor business (now known as Endeavour Drinks). There’s a reason Woolworths wants us to focus on Endeavour Drinks separately – its performance is first class. Sales in 2016 rose 5% to $7.6bn while operating earnings rose 3% to $484m.
The separation was a clever move designed to show how much better Woolworths’ liquor business is than Coles’. On Wednesday Coles’ management admitted its liquor business was still struggling although it had returned to positive same-store sales growth after many years of going backwards. In 2016 Endeavour Drinks reported market share gains and 2.0% same-store sales growth for the year.
Woolworths' and Coles' positions are clearly reversed when it comes to supermarkets. Woolworths food and petrol business reported sales down 3% to $39.4bn and operating earnings down 41% to $1,760m as it lowered prices and invested in service. But with second-half transaction growth of 2.6% and its ‘Voice of the Customer’ satisfaction score finishing the year at a record 75%, customers are returning. Management also reported improving stock availability and an end to the technology issues that were plaguing its food business.
|Year to 30 June||2016||2015|| /(–)
|* Interim dividend 33 cents, ex date 8 Sep|
|Note: Figures are underlying results|
Big W is still broken. The general merchandise retailer reported a loss of $15m and, like Wesfarmers’ Target, will take years to turn around. New Zealand supermarkets and Hotels, though, are performing just fine, despite small profit declines.
The other good news is that the end of Woolworths’ home improvement disaster is in sight. Masters will cease trading in December, with the inventory sell-down being managed by an inventory disposal firm and the Masters sites being sold to a property consortium. Home Timber & Hardware Group is being sold to Metcash. Woolworths expects to realise net proceeds of $500m from the sale before any payments to joint venture partner Lowes.
So everything’s hunky-dory, right? Well, perhaps we’re being too conservative but we think the market is getting way ahead of itself. Woolworths didn’t provide 2017 profit guidance for the very real reason that there’s unlikely to be much of a recovery this year. Flat earnings would be a good result but a decline seems much more likely.
While the provisions and writedowns taken in 2016 will provide a benefit to 2017 earnings, it won’t be enough to offset the annualised effect of the $1bn invested in price over the past 18 months. And it’s very unlikely that same-store sales growth is going to accelerate sharply from here. Even if it did, both Woolworths and Coles will need to keep reinvesting in price to remain competitive.
Woolworths’ 2016 earnings per share came in at $1.23. That’s significantly lower than the $1.45 we expected at the time of our original upgrade in Woolworths takes tough decisions on 29 Oct 15 (Buy – $24.70). While a price-earnings ratio of 20 is not crazy-high for a quality business near (but probably not at) its earnings nadir, nor is it good value. For that reason we’re lowering our recommended Buy price to $23 and downgrading our recommendation.
While we’ve had confidence in the strength of Woolworths’ business, the market now seems too enthusiastic about the size and timing of the recovery. Certainly management has made some progress but earnings will not increase sharply from here. And there remains a risk that Coles will respond with its own round of price investment.
In truth we would have been happier had the news from Woolworths been worse. As it turns out we think Woolworths’ share price has run too hard given that the turnaround has only just begun. HOLD.