How Soon Can Woolworths Turn Around?

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

-FY16 profit decline expected
-Dividends under threat
-CEO uncertainty
 

By Eva Brocklehurst

Woolworths ((WOW)) is flying the distress flag. While some moves are being made to address its problems, brokers remain to be convinced as to how soon the ship can be turned around.

Profit is expected to decline in FY16 on the back of continued weakness in food & liquor. Price and labour investment will increase in FY16, but sales trends remain weak. Promotional activity increased in the second half, reducing gross margins. This also showed in an acceleration in deflation to 5% in the June quarter.

Citi believes price investment needs to be better targeted, given promotional effectiveness has been poor, and suggests more staff and better marketing could help. The broker expects the decline in earnings in FY16 to be significant and a change of management is the potential catalyst for a re-set of earnings. The company has just installed a new chairman, Gordon Cairns, and the CEO, having announced his retirement in June, now has to be replaced.

The stock is expected to trade lower as the reality of its earnings downside sinks in. Citi also wonders how much the reduction in incentives will impact staff morale, suspecting the drop in bonus payments will impact execution and slow down a recovery.

There is also a disparity between the commentary regarding the home improvement division and the financial results. Credit Suisse observes the earnings loss in the division increased 16% in the second half while sales have shown minimal improvement. It appears the market will have to await the new CEO to obtain further clarity on this.

Credit Suisse believes capital risks are centred on either a prolonged downtrend in supermarket profit, which would reflect a failure to address the issues, and/or a potential call on cash if Lowe's were to put its option on the Masters JV in play.

Woolworths has provided no guidance for FY16. Credit Suisse maintains its dividend forecasts at the current level, which would result in the pay-out ratio increasing to 80%. This is not considered sustainable over the longer term and, hence, there is downside risk to dividends in the broker's opinion. Morgan Stanley concurs, expecting margins are likely to be a lot lower in the years ahead. The broker suspects dividends will be cut this year.

UBS makes modest downgrades to its FY16-18 estimates, largely because of cuts to Big W and Masters. The broker believes Woolworths has lost its way, taking margin at the expense of sales and customers. It is likely to take around 24 months to return to a defendable sales growth trajectory, UBS suspects. Along the way there is the risk of a major re-basing of earnings and margin.

Moreover, the aggressive rhetoric regarding price investment increases the risk of a reaction from competitors, in the broker's opinion. UBS, too, suspects the FY16 dividend may be at risk. The balance sheet is robust and the recent downgrades by ratings agencies do not have a material impact on funding, but this does limit the scope for the company to maintain the dividend if earnings fall.

UBS also observes there is no short list for the CEO replacement and the appointment could be some way off. Poor price perception and aggressive competitors that will not stand idly by are an enduring threat, in JP Morgan's view. The timing of the CEO's retirement is considered unfortunate as it destabilises the implementation of the company's strategy.

To Deutsche Bank the efforts so far are not resonating with customers and the path to improvement remains unclear. The "Cheap Cheap" campaign will be phased out, consistent with anecdotal evidence the broker has heard that it has not been beneficial to the company's value perception.

The broker acknowledges the value in the assets but believes it is too early to invest. The downside risk, in Deutsche Bank's view, centres on a potential inability to improve the value perception while upside risk is a smaller margin dilution than feared from the price investment strategy.

Morgans agrees that with so much uncertainty in the supermarket business and a transition to a new leadership team, investors should remain cautious for now. The broker continues to advocate a measured long-term approach to the Masters business, as there is a significant opportunity in such a market. Nevertheless, a profitable result is not foreseen until FY20.

The new format stores are delivered better average sales, which Morgans finds encouraging. Management needs to convert all stores to the new format, maintain the 30% uplift in sales in each, and hold costs flat. Then, in the broker's view, it will be able to break even. But this should take 3-5 years.

Despite the challenges, Morgans maintains a dividend forecast of $1.39 over the next few years, in line with FY16, believing the board will aim to maintain shareholder returns and underpin confidence in the turnaround.

FNArena's database has three Hold and five Sell ratings. Consensus target is $25.36, signalling 3.4% downside to the last share price. Targets range from $21.00 to $28.00. The dividend yield on both FY16 and FY17 forecasts is 5.1%.
 

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