Woolies Heading To Hardware Hell?

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

By Greg Peel

In the mildly successful Australian movie “The Bank”, released several years ago, Anthony La Paglia plays a CEO who was brought in by the board in the preceding year to tidy up the (fictionally ASX-listed) bank in question and to re-establish solid shareholder returns. La Paglia’s character is successful in the challenge, aggressively cutting costs and reworking services until finally achieving earnings growth of 20%. But just when the CEO believes he can now rest on his laurels, the bank’s board puts to him the question as to what he is planning to do to achieve another 20% earnings growth in the next year. The CEO suddenly realises that by being too good at what he has done, he has dug himself a hole. The shareholders will now expect 20% growth every year – at least.

And that is the nature of listed companies. Unless you are a strict yield-play, or “value” stock, such as an investment trust or utility, the market expects you to continually grow earnings, not simply post consistently solid earnings. Investors expect growing shareholder returns based on share price appreciation as well as dividends. And thus as so often is the case, a company at the top of its game, perhaps dominant in its sector, is forced to take that one step too far – to make that investment, acquisition, or strategic or geographical expansion on behalf of the shareholders that never really made great commercial sense in the first place.

While the retail sector is one in which growth opportunities always lie, consumer staple companies run into the problem of saturation. Supermarkets are such an example. How many supermarkets can you open in a city before they begin to cannibalise each other’s market? Woolworths ((WOW)) had already reached such a point, and dominated it competitors, before taking the offshore example of moving into petrol and liquor for a new source of earnings growth. So successful was the move, Woolies now dominates those areas as well. But again, Woolies is stuck. It has provided solid shareholder returns to date, but as August’s The End Of The WOW Factor? suggests, stock analysts are struggling to see what Woolies can do next.

But Woolies has a plan. It is going to take Bunnings head on in the lucrative “big box” hardware market. In so doing, it should prove another thorn in the side of competitor Wesfarmers ((WES)) – owner of both Bunnings and supermarket competitor Coles. The plan will be implemented under a joint venture with US big box leader Lowe’s, and in preparation Woolies has acquired local hardware wholesaler Danks. But is it really a commercially sensible move?

For a long time in the market, Merrill Lynch (now Bank of America owned) has been the most ardent critic of listed companies making life-changing acquisitions and expansions. Merrills was the most critical of Foster’s ((FGL)) takeover of Southcorp – correctly so as it turned out – and has never been a fan of Wesfarmers’ acquisition of Coles. Now the broker has turned its sights on Woolies’ hardware expansion plans.

When Woolies announced its bold new move ahead of its FY09 profit result in August, most analysts were circumspect. They saw in hardware a business which was unlikely to ever match Woolies’ dominant margins in food & liquor, but a mild source of earnings growth nevertheless, albeit not until at least FY12. The FNArena database presently shows a 3/6/1 Buy/Hold/Sell ratio for the stock, with the bulk of Holds a result of analyst belief the stock is already fully priced.

But no prizes for guessing who the lone Sell (Underperform) might be. In short, Merrills calculates Woolies’ move into hardware could cost shareholders up to $2.00 in shareholder value. The analysts are quite candidly expecting Woolies to fail.

I, personally, was greatly disappointed recently when my local suburban hardware store, part of the Mitre 10 cooperative, shut its doors. It was of little surprise however, given I live only ten minutes from a Hardware Hell, aka Bunnings. That’s ten minutes to reach the store of course – actually parking can take a lot longer than that. And once inside, you’re on your own. Ask any red-shirted employee in which aisle one might find the widgets, and nine times out of ten you’ll be directed to the wrong one. Then, having searched and found said widget alone, try asking another red-shirt whether such widget is indeed best for the job at hand. My favourite part comes when a startled looking red-shirt answers the question by reading out the label.

We don’t go to Bunnings because it’s easy to park, or because the service is superior, or even because it’s that much cheaper (which often it isn’t). We go to Bunnings because it’s a one-stop shop. Everything one might possibly need is most likely there – somewhere. As Ikea is to household items, Bunnings is to hardware.

Bunnings has been in operation for 25 years – very successfully. It started on the west coast, and was initially mimicked on the east coast by then incumbent BBC Hardware, owned by then listed company Howard Smith, which tried to go “big box” with its Hardwarehouse stores. But as Merrill Lynch points out, BBC tried to recoup the cost of real estate on such warehouses by putting prices up and reducing staff and subsequently failed, only to be later swallowed up by Bunnings.

With 160 stores, Bunnings dominates the Australian hardware market, being three times the size of its nearest competitor, the aforementioned diminishing Mitre 10. Aside from existing stores, Bunnings also boasts a “land bank” of property acquired for future stores. Bunnings manages its vast properties by spinning them off into a REIT-style investment vehicle, the Bunnings Warehouse Property Trust ((BWP)), and leasing the sites back. It employs an average 60 staff per store, with little emphasis on industry knowledge (most would be thrown if you asked for the old tricks – a left-handed screwdriver, a metric shifting spanner, or a can of striped paint, for example).

The Woolies/Lowe’s competitor (as yet unnamed) is starting from scratch. First it must undergo the expensive exercise of securing suitable land, and Merrills suggests that potential sites Bunnings hasn’t already secured in suburban Australia, either with a store now established or pending, would have been rejected by the incumbent. Woolies is fighting John West.

Woolies believes it will have 150 hardware stores in Australia within a five-year period. Merrills believes that target to be “unfathomable”. The analysts suggest that if 80 stores have opened, Woolies will be doing well. And Bunnings could also have hit 240 stores by the time Woolies opens Store One.

Woolies intends to attack Bunnings with higher quality service. Merrills can’t see how the company could achieve this without paying more in labour costs, thus starting from a lower margin.

Woolies wants to go head to head with Bunnings on location, rather than simply trying to fill a void Bunnings hasn’t to date (if there is one). Woolies will thus need to drag customers out of Bunnings, something Merrills can’t see being achieved except on price, again meaning lower initial margins. Woolies will need to establish cost-efficient relationships with local suppliers, but Bunnings has a big head start. Woolies will be relying on US market leader Lowe’s providing cheap offshore supply sources, but the bulk of Australian hardware is sourced in Australia, and Merrills suggests that while Lowe’s might have great experience in the US, is blissfully ignorant of the local market.

Then there’s the small matter of newly acquired wholesaler Danks, which supplies all Australian hardware outlets, including Woolies soon-to-be competitors. The conflict of interest could prove a minefield for Woolies, Merrills suggests.

And finally, Woolies has suggested that big box hardware is a $24bn a year market in Australia. Merrills believes Woolies has made a grave error in mistakenly including commercial-sized garden equipment in that estimate, which is not a typical Bunnings-type retail line. The analysts estimate the true market within which the new Woolies stores will compete to be more like $12bn a year – a figure agreed to by an independent industry source.

The Merrills analysts, in conclusion, despair at Woolies move into hardware, and suggest “failure looks imminent”. This is not a spiteful assessment, given the same analysts are big fans of Woolies “wonderful” food & liquor business. They simply hope that Woolies “acts rationally on its move into hardware” and “doesn’t make decisions on haste”. Because the Merrills analysts don’t believe management has really thought this one through.

And there is an unfortunate precedent, being Woolies’ largely failed move to take on an incumbent competitor in the New Zealand consumer electronics market.

After a lot of number crunching, and various assumptions, Merrill Lynch believes an abortive assault on Bunnings could cost up to $2.00 in shareholder value.

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