Woolworths Adds More Uncertainty To Outlook

This story features WOOLWORTHS GROUP LIMITED. For more info SHARE ANALYSIS: WOW

-High chance earnings re-based
-Masters remains a thorny problem
-Is an exit from Masters likely?
-Supermarket issues taking time
 

By Eva Brocklehurst

Sales momentum continues to be sluggish for Woolworths ((WOW)) which, a month after acknowledging it has made mistakes, has lowered FY15 guidance to be in line with FY14. Chief executive Grant O’Brien also announced his resignation and a search is now underway for a replacement. Mr O’Brien will remain in the job until a new CEO is appointed.

The resignation is the main issue for brokers as it clouds the outlook despite the transformation plans that are ongoing and were only announced only a month ago.The chairman signalled a new CEO will not be tied to the 5-year plan. More uncertainty. Morgan Stanley believes an external appointment is required. Someone who will bring a fresh approach and experience in global supermarkets. The risk is that a new CEO may re-base earnings estimates, creating further downside risk for FY16.

The problems are deep and sales growth will remain under pressure as price investment continues, brokers contend. Recent initiatives appear to have had little impact, although Morgan Stanley concedes a new CEO could turn out to be a positive development. Deutsche Bank is of a similar view, suspecting the CEO’s departure may provide the opportunity to make the adjustments that are needed. Still, the broker is not all that confident the board will appoint the right candidate. Deutsche Bank is not as concerned as some about the impact of Aldi but believes it is too early to invest in Woolworths given the negative momentum and the prospect of a re-basing of earnings.

Citi suspects an earnings re-base in the order of 20% could well be possible under a new CEO. The brand needs a leader who can manage a diverse mix of retail businesses, a skills combination that is more likely to come from offshore, in the broker’s view. Macquarie flags the board’s observation that it did not believe grocery experience was a necessity for the role and considers the announcement rushed in the face of a poor trading update, given the lack of a succession plan. Macquarie believes management change is a first step to restoring investor confidence, but a subsequent re-evaluation of the strategy is likely to result in an extended period of underperformance.

A combination of the premature departure of the CEO and a downgrade to earnings guidance tilts the balance of risks too much to the downside for JP Morgan. As a result the broker downgrades its recommendation to Underweight from Neutral.

The seemingly intractable problems with the Masters hardware venture were not dealt with in the latest announcement, and Credit Suisse maintains the necessary step-change in sales to justify ongoing investment appears unlikely to eventuate. Thus Masters remains a knotty issue for the future. Several brokers canvas a view that Woolworths could exit Masters. Credit Suisse believes this could occur with a minimal cash requirement, based on an assumption of the land value upon liquidating the assets.The departure of the architect of the Masters venture, Grant O’Brien, makes an exit more plausible, in Morgan Stanley’s opinion.

Hypothetically, Citi estimates it could cost $300-900m to exit the venture. There could be some recovery through asset sales while the value of partner Lowe’s put option may be smaller than the current book value. Any exit is considered more likely in 2016 than 2015.

Brokers agree Woolworths is a strong supermarket franchise but became intent on margin at the expense of sales and customer focus. Morgan Stanley has long argued that Woolworths lifted prices too quickly, which supported margins but left customers unhappy. The fact that Australian food & liquor growth has turned negative in the current quarter is very disappointing, given the step-up in price and labour investment, and UBS suspects it will take at least 24 months to return to a defendable growth trajectory. Credit Suisse bemoans an overly centralised structure and complex product range. Store service levels also require improvement. These operational issues are addressable but Credit Suisse also believes it will take time. Citi calculates that margins of 6.2% are sustainable, which is a long way from the 8.0% witnessed in FY14.

The consensus target on the FNArena database is $26.97, which signals 2.1% upside to the last share price and compares with $28.77 ahead of the announcement. The dividend yield on FY15 and FY16 forecasts is 5.2% and 5.1% respectively. There are no Buy ratings on the database, with three Hold and five Sell.

See also Woolworths Changes Tack But Is It Enough? on May 7 2015.
 

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