Woolworths Changes Tack But Is It Enough?

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

-Capex focus on supermarkets
-New Masters roll out halted
-Price matching, not leading
 

By Eva Brocklehurst

Brokers define May as the "confession season" ahead of end of financial year and Woolworths ((WOW)) did just that, acknowledging mistakes were made and that  it took its eye off the main game in terms of looking after customers. The company presented a transformation plan which involves better capital allocation and a renewed focus on its supermarket chain to compete with rivals.

Third quarter sales were softer than expected, particularly in food & liquor, where like-for-like growth was just 0.2%. The company stated it would invest in price because of a need to be perceived as cheaper. Woolworths will also reduce FY16 capital expenditure to improve cash flow. The underperforming Masters business will be required to prove its new format before further expansion capital is allocated.

Several brokers were disappointed with the lack of a major shift in strategy. The supermarket recovery path is long-dated and uncertain and Macquarie suspects investors may become impatient after several years of underperformance. Woolworths has chosen a less aggressive stance towards its rivals than it presented at its first half results, choosing to match prices rather than lead. This suggests a slow grind to the broker, with no catalyst to drive a turnaround in price perceptions. Macquarie retains an Underperform rating and prefers Wesfarmers ((WES)), whose Coles supermarket chain has materially diverged in growth terms, having reported substantially stronger sales over the March quarter.

New store targets for Masters have been halted and there is no net increase in store numbers for Big W. Credit Suisse believes the strategy could have gone further, by reducing the rate of expansion in the supermarket store network, at least in the short term, but a 15-25 store per annum target was maintained.

Morgan Stanley also considers the changes are incremental and not what is needed to improve earnings sustainably. Since price investment will lower sales growth, not lift it, the broker believes it inevitable that profits will be lower in FY16 than in FY14. Morgan Stanley would have liked to see a slowing of supermarkets roll out as well as a step change in supply chain efficiencies, driving sales per square metre growth. The broker also wanted an acknowledgment of the impact of Aldi and a strategy to compete with the newcomer.

UBS warns Coles and Aldi will not stand still while Woolworths turns its ship around. The new approach is the right one but regaining momentum will take time and cost money. While FY15 guidance was reiterated, the broker considers it at risk, particularly given a disappointing sales result in April. The business had lost its way, having been too intent on the short term and taking margin at the expense of sales. UBS considers it will be at least 12-24 months before the sales growth trajectory returns to a defendable position and along the way there is a real risk of a major earnings and margin re-base. Sell maintained.

JP Morgan is more confident, upgrading to Neutral from Underweight on the basis the company has started to make changes. The broker is mindful that the promises need to be followed up with execution, but the underlying business is considered strong and there is plenty of potential.

The admission is a step towards addressing the problems facing Woolworths, in Deutsche Bank's view, but despite previous comments to the contrary the broker was disappointed that Woolworths is more expensive than Coles. The downturn in April suggests that large investments in price and service have not yet delivered any benefit. The broker noted the significant attention to pricing and service at the briefing but was surprised to find little detail on marketing.

Deutsche Bank notes the company's statement that it would neutralise Coles' ascendancy on price and contain Aldi's advance, which makes a price war less likely. Still, confidence was dented by the deterioration in April trade. At current levels the market is pricing in material contraction in margins. While ultimately the sales trend can improve, given asset quality, Deutsche Bank considers it is too early to invest, retaining a Hold rating.

Fundamentally, the business is strong but needs to be reinvigorated to drive a re-rating, in Morgans' view. The broker would be a buyer at $25-26 in the short term but, if the share price remains around $28, improvement in sales growth needs to be evident before being confident to buy the stock again. Morgans welcomes the shift away from earnings to a focus on the customer but finds it unfortunate that the company has to play catch up with Coles, as this means earnings growth will likely be under pressure for at least the next 12 months.

There are no Buy ratings on FNArena's database for Woolworths. Just four Hold and four Sell. The consensus target is $29.01, suggesting 4.5% upside to the last share price, and compares with $29.39 ahead of the update. Targets range from $24.00 to $32.70. The dividend yield on FY15 and FY16 estimates is 4.9%.
 

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