No Quick Fix For Woolworths Margins

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

Woolworths saw sales improvement but an earnings miss in the September quarter due to margin pressure from strapped consumers. Brokers also remain concerned about the company’s costly investments.

-Woolworths’ Q3 update revealed margin pressure
-Aussie consumers feeling the pinch
-Significant investment yet to drive earnings
-ACCC yet to deliver its recommendations on supermarkets

By Greg Peel

Woolworths Group ((WOW)) and rival Coles Group ((COL)) remain under a regulatory cloud. Governments have tried over the decades to break a perceived duopoly through regulation but have had little success in proving anti-competitive practices. The latest move comes following accusations of rampant customer rip-offs in “discount” promotions. The ACCC has to date issued an interim report, with the final report due in February.

Said accusations followed closely behind a Choice magazine survey which found Aldi offered the best value.

Key issues identified in the ACCC’s interim report were: (i) price setting practices; (ii) consumer experience; (iii) retail competition; (iv) profitability and margins; and (v) grocery supply chains. Overall, there were no recommendations, with more hearings to be held over October/November involving executives of Aldi, Coles, Metcash ((MTS)) and Woolworths for the final report.

No specific conclusion on supplier concerns raised was made in the report, with more formal hearings and case studies planned around supply chain, prices and margin.

Writing on the release of the report in late September, Jarden suggested the final report, which will include recommendations to the Australian government, will likely have recommendations on land-banking, price establishment periods and supplier engagement in fresh produce.

Jarden saw material negative recommendations as unlikely.

September Strain

Woolworths’ Australian food total sales growth improved during the September quarter, beginning at 3.0% and improving to 4.8% by quarter’s end for an average 3.8% growth, assisted by a collectibles program late in the quarter, UBS points out. Yet the shift to value by consumers and a desire by Woolworths to maintain sales momentum it built in the June quarter FY24 following a weak March quarter, had a negative impact on earnings and margins.

First half earnings guidance provided came in -7% below consensus.

Margins were negatively impacted by highly value-conscious customers buying more products on special and trading down to lower priced items such as own-branded products. The strong growth in lower margin eCommerce of 23.6% also adversely affected the sales mix when compared to store-originated growth of 0.7%.

In simple terms, consumers have been under cost-of-living pressure and are shopping accordingly. Pressure is not expected to ease until the RBA starts cutting rates, which is not expected before next year.

Woolworths has announced plans to optimise promotions and prudent cost settings for the December quarter, with yet more to come in the second half of FY25.

Too Complex?

Woolworths has not always been prudent in capex and opex in recent years, UBS suggests, with growth the dominant priority versus cost management. Hence, there is significant investor desire for cost savings to be announced, although questions exist about execution capabilities.

The company has created the new W Living division which includes Big W, PetStock, and the emerging businesses of Healthy Life (online pharmacy, telehealth) and Woolworths Market Plus (B2B platform for suppliers). The first half FY24 loss for emerging businesses has been disclosed and UBS expects greater scrutiny to result in a heightened focus on growth and a path to profitability.

There was a lot to unpack in the quarterly update, Jarden notes, particularly with respect to the Aldi impact, online economics, whether Woolworths has become too complex and the extent of losses across new(er) businesses. Ultimately, the latter broker believes Woolworth’s costs did not adjust quickly enough and the business lifted discounts under its new CEO, compounded by a consumer more actively seeking value.

Jarden expects to gain clarity on the extent to which these issues are Woolworths-specific or a sector issue in coming months. Near term, it is clear to the broker headwinds will not subside. The key investment decision for Woolworths is whether it can more actively streamline costs and monetise online (profitably) and whether, as consumer spending improves and inflation steadies, its share can re-accelerate (profitably) as is evident in the UK and, to a lesser extent, the US.

Near term, Jarden has cut its FY25 earnings forecasts reflecting the food downgrade, higher losses in new business and removal of the final Endeavour Group ((EDV)) stake (and dividend).

Jarden believes Woolworths’ cost base is too high and the business may have become too complex to adjust to short-term market shifts. The broker remains positive and believes a stabilising market could lead to a re-acceleration of market share and profit. However, the trading update suggests the risk of a step-up in industry discounting/competition and step-down in margin has increased materially.

Despite positive factors like lower tobacco sales and growth in Cartology/media (data collection and IT hocus pocus), supply chain investments, eCommerce, and price investments are creating headwinds, notes Ord Minnett. Woolworths aims to improve customer perceptions and close pricing gaps with competitors like Chemist Warehouse Group ((SIG)), Bunnings ((WES)) and Aldi. However, eCommerce growth outpaces store growth, necessitating tighter cost management or price increases to enhance profitability.

Woolworths’ strategy of investing in start-up operations is questioned as it has lost market share over the past 12-18 months. The ACCC is scrutinising the competition implications of the company’s retail ecosystem. Investors may demand a review and clear profitability plans for loss-making businesses, Ord Minnett suggests.

On the plus-side, management noted Australian food is on track for hundreds of millions of dollars of productivity in FY25 and several initiatives are being accelerated including support cost optimisation, stock loss mitigation and organisation simplification. Goldman Sachs believes the continued growth of high-margin Retail Media (Cartology) will further enable Woolworths to invest in price to gain share.

Woolworths is seeking to build sales momentum in food via higher volume rather than price. Positively, notes Macquarie, this strategy is driving momentum across the remainder of the business. For example, New Zealand food comparable sales are outperforming Australia’s, and Big W sales growth has been improving as Woolworths refines its offering, though Big W is still underperforming rival Kmart ((WES)).

Value?

Woolworths’s share price has fallen around -17% since mid-August, in the wake of value comparison (Choice), regulatory scrutiny (ACCC) and the first quarter update. Longer term shareholders will note the stock is trading at the same level it did in early 2020.

Brokers agree there will be no let-up in cost-of-living pressure, which is the underlying driver of Woolworth’s margin struggle, through Christmas 2024.

Woolworths’ FY25 earnings are projected to fall by -14%, with capex spending at 1.6 times (ex-D&A). Management plans similar capex levels for FY26, raising concerns for Ord Minnett about spending without share gains or earnings growth. Margin pressures are expected to continue into the second half of FY25, with supply chain headwinds increasing.

Ord Minnett retains a Hold rating.

Citi believes there is more work to improve the image around brand and price perceptions. The view is further earnings downgrades remain possible, hence Citi downgrades to Neutral from Buy.

UBS retains Neutral despite earnings downgrades as Australian food is a market leader with long term potential, provided execution and cost management improves.

In Morgans’ view, Woolworths is a good, defensive business with dominant market positions and long-term earnings tailwinds from increased operating efficiency and population growth. Despite these qualities, this broker sees current valuation as full given the subdued earnings growth outlook, and thus sticks with a Hold rating.

The margin outlook will remain a source of downside risk until the consumer environment improves, Macquarie suggests, and regulatory oversight alleviates. Despite the stock trading towards post-covid lows, Macquarie retains Neutral.

That just leaves Morgan Stanley among brokers monitored daily by FNArena covering Woolworths. Morgan Stanley’s trading update response was typically brief, but the broker did note management is aiming to improve promotional effectiveness as well as adopting prudent cost settings for the December quarter to address margin weakness, in retaining its Overweight rating.

Post the update, and subsequent earnings forecast downgrades, the consensus target between the above brokers has dropped to $34.12 from $37.08.

Woolworths’ balance of one Buy or equivalent rating and five Hold (among daily-monitored brokers) compares to five Buy and two Hold ratings for Coles ((COL)), noting Bell Potter covers Coles but not Woolworths.

Post Woolworths’ update, Jarden retained its Overweight rating but looked to actively review its sector view post Coles’ quarterly results. Jarden thereafter retained a Neutral rating on Coles. Jarden cuts its Woolworths target to $37.30 from $38.60.

Goldman Sachs also has a Neutral rating on Coles, and a Buy on Woolworths on “long term competitiveness”, cutting its target to $36.20 from $38.90.

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