Post Masters Exit, Woolworths Challenges Remain

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

-Woolworths future now more leveraged to grocery
-Facing significant competition
-Needs to make non-price investment
 

By Eva Brocklehurst

Woolworths ((WOW)) has succumbed to a view that brokers have been forewarning of for some time, announcing the exit of its loss-making Masters hardware joint venture, having evaluated it would take several more years before the business became profitable.

Woolworths will purchase joint venture partner Lowe's put option over its 33.3% stake and, with 100% of Masters, then pursue the sale or winding up of the business.

The decision is a relief to brokers as it exits a business which has been a significant drag on cash flow. Nonetheless, as JP Morgan highlights, it also removes the company's access to an otherwise large and profitable industry.

What went wrong? JP Morgan contends the rationale to enter the industry was sound but Woolworths was constrained by poor execution on its strategy. The accumulated tax losses may be used going forward so the decision to exit is a net positive.

Deutsche Bank considers the venture into hardware was a case of "easier said than done”. The main problem was that sales per store were not high enough to cover the relatively high in-store costs and expensive supply chain, which relies on a distribution centre arrangement. In this scenario, competitor Bunnings, owned by Wesfarmers ((WES)), had a significant head start, with 259 locations servicing customers already when Woolworths decided to enter the market.

It was always going to be difficult to obtain good sites, Deutsche Bank observes. The acquisition of Danks in 2009, which provided the Home Timber & Hardware (HTH) brand, assisted with local hardware supply while the partnership with Lowe's provided access to global supplies.

However, securing brands which resonate with consumers was difficult in several key categories, the broker maintains. Deutsche Bank also observes it was difficult to change consumer behaviour in a category where purchases are only made several times a year.

The main beneficiaries of the decision to exit are considered to be rival hardware store owners, primarily Bunnings, as well as Metcash ((MTS)) which supplies the Mitre 10 brand. Assuming Masters is wound up, brokers expect Bunnings to access some of the sales revenue, either directly or via the acquisition of some of the stores.

For Metcash, the Danks wholesale business could be of interest, brokers contend. HTH is profitable, unlike Masters, but Woolworths has signalled it will be sold in the interests of shareholders. Deutsche Bank notes HTH generated $20.9m in earnings for Woolworths in FY15 and calculates this implies a valuation around $200m.

Woolworths paid $87.6m for Danks but has outlaid considerable capital expenditure since 2009, the broker contends. Regardless, brokers believe the main issue will revolve around whether the ACCC would let Metcash acquire the Danks network.

If no buyer emerges for Masters – something most brokers consider unlikely – Bunnings could accelerate growth in space by targeting Masters' site conversions. Mitre 10 is considered a logical partner for the HTH business, with some synergies likely, and, with limited bidding tension in Macquarie's view, given competition concerns for Bunnings.

While Masters is differentiated and has a much larger footprint, Macquarie contends the acquisition of sites could provide an avenue for Mitre 10 to enter the “big box” segment of the home improvement market. The broker expects a sale of the Masters assets is the most likely outcome and likely to be sold separately to a number of bidders.

Food & grocery is also at the nub of the decision for Woolworths. Short term earnings and free cash flow may improve but brokers maintain the company is now more leveraged in the longer term to a low-growth grocery industry, which is undergoing significant competitive and structural change. Morgan Stanley continues to envisage risks to food & liquor margins and considers the current valuation of Woolworths is therefore stretched.

The broker believes a winding up of Masters is the most likely outcome and factors in its occurrence by the end of FY16 with proceeds to eventuate in FY17. Morgan Stanley expects the board will move swiftly, allowing it to re-focus on its supermarkets business, which is likely to be under pressure from the expansion of both Aldi and Costco over 2016.

Valuation of the Lowe's option is still to be determined with independent experts being retained to evaluate the sale. This put option remains the main swing factor in broker calculations of the ultimate benefit to Woolworths from the exit. Woolworths expects to take two months to complete this process. UBS expects the valuation of Masters to be written down materially from the last reported valuation of $2.7bn.

In tandem with this announcement, and in contrast to the woes at Woolworths, Wesfarmers also issued further detail on it expansion of the Bunnings business into the UK, with the acquisition of the Homebase brand there. Brokers maintain Bunnings is in the box seat to capture a material share of the Masters business, while elsewhere, Wesfarmers is performing strongly, with its Coles supermarket business also leading the segment.

UBS expects the decision to exit Masters will remove a distraction for Woolworths management, allowing it to focus on the underperforming food & grocery business and make it easier to appoint a new CEO. The December quarter, according to channel checks, was tough for the grocery division and UBS remains cautious on the stock, retaining a Sell rating.

Woolworths is Australia's largest grocery retailer, with a 40% market share and the Australian food & liquor business contributes over 80% of total earnings. Industry feed back suggests to Macquarie that the sales growth differential between Woolworths and Coles is widening, with volumes not responding to price investment.

Macquarie believes the Masters exit will free up capital to invest in supermarkets and it will be the successful execution of these funds which will ultimately determine the value of exiting the Masters business. While having the capital available does not guarantee a successful turnaround of the supermarket business, it does provide the opportunity.

The broker contends a new CEO and a refreshed strategy – with investment in non-price areas of the supermarket business – will be the most important driver of a turnaround for Woolworths. This includes refurbishment, staffing, supply chain and marketing and needs to be initiated before the broker becomes more confident in the turnaround.

Morgans believes it is too early to re-visit the stock. The broker is disappointed the company has decided to exit the Masters business, despite acknowledging the execution of the business plan has been poor. The broker believes it will be difficult for earnings to grow much more than by mid single digits over the medium term. Any short-term strength in the share price is likely to be an opportunity to trim any overweight positions in the stock, in the broker's opinion.

Woolworths has three Hold and five Sell ratings on FNArena's database with a consensus target of $23, suggesting 1.0% upside to the last share price. The dividend yield on FY16 and FY17 estimates is 4.7% and 4.9% respectively.

In comparison, Wesfarmers has two Buy, five Hold and one Sell rating. The target is $40.85, signalling 3.9% upside to the last share price. The dividend yield on FY16 and FY17 estimates is 5.2% and 5.5% respectively.

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