Pain Continues For Woolworths

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

-Earnings margins fall
-Turnaround long dated
-CEO instigates review
 

By Eva Brocklehurst

The pain contines for Woolworths ((WOW)) with additional investment in price announced for the food & liquor business, indicative of the intense competition in the supermarket segment.

Meanwhile, like-for-like sales growth remains elusive, brokers observe, and this is compounding the dilution from ongoing price investment. The company's decision to move to a new operating model to allow the CEO to focus more on Australian food & liquor is just the start of a 3-5 year journey to turn the business around, Deutsche Bank contends.

Australian food & liquor like-for-like sales were slightly softer in the March quarter, down 0.9%, and the company also announced that Big W would record a small loss in FY16. A broader review of the business by the newly appointed CEO, Brad Banducci, is occurring, with an update expected ahead of the FY16 result.

With the uncertainty about whether sufficient investment is being made and the risk that the base level of earnings margins in food, liquor and petrol are not achieved, Ord Minnett retains a Lighten rating.

Earnings margins have fallen significantly, yet further investments may be required to drive sales growth and this is difficult as the competitive environment is increasingly challenged. Hence, this broker also expects the duration of the turnaround to be long and with it, risk remains elevated.

The $150m investment in price started in March, with the majority of the investment spread over the following three months. Macquarie observes improved trading in April in food & liquor but cautions against extrapolating this further, given the likelihood of a competitor response. The broker believes the need for additional investment, and the results to date, highlight the continued deterioration in supermarket operations.

The broker observes petrol sales fell 8.7% in the quarter and were driven by an 8.0% reduction in average fuel selling prices. The fall resulting from lower fuel prices will not affect profitability on its own, the broker maintains, as the sale price does not materially change the margin made by Woolworths. Of more significance, comparable fuel volumes continued to decline as competition intensified.

The broker observes merchandise sales at the Woolworths petrol sites slowed significantly and underperformed the Wesfarmers ((WES)) petrol division, which grew comparable sales by 8.1% in the March quarter. Meanwhile, New Zealand supermarkets are being affected by deflation. Comparable sales increased 0.6% in the March quarter and sales were negatively affected by movements in the AUD/NZD.

The issue with Big W primarily centred on a poor response to new season ranges, which Macquarie believes reflects poor merchandising in 2015. The profitability of Big W will be materially affected by ongoing clearance activity for summer and winter apparel. Meanwhile, indicative offers for the home improvement division (Masters, Home Timber) have been received with more than six parties understood to have submitted bids.

Credit Suisse stands out on the FNArena database with its Outperform rating. The broker acknowledges the trading performance is unlikely to improve in the short term and there are risks around execution of the chosen strategy, but the March quarter result was locked in before current management arrived. The broker notes several positive steps have been taken with a change in operating models for merchandise and moving global sourcing back to Big W from a group function.

Expenditure in supermarkets appears to be focused on maintaining competitiveness in the fresh categories while the company is addressing its poor competitive position in the centre of the store through re-branding of private label and initiatives to simplify ranges and reduce costs. The broker expects the benefits of fixing system issues to be forthcoming in FY17 with a gradual improvement in sales growth.

Morgans believes it is too early to be a buyer of Woolworths stock. Earnings estimates are reduced by 8.2% and 6.5% for FY16 and FY17 respectively. While the broker acknowledges some progress is being made on strategic issues, significant fundamental challenges remain. The broker believes the supermarket industry will remain tough for some time to come and awaits the operational review before reconsidering the stock, retaining a Hold rating.

UBS sticks with a Sell rating, suggesting the company is investing more just to stand still and there are no visible signs of a turnaround as yet. While FY17 estimated food & liquor margins will be down 350 basis points from peak levels, the broker will not consider FY17 as a new base until there are signs the like-for-like sales in supermarkets are improving.

The improvement in April was against an easier comparable period, the broker warns. UBS considers the price investment signals the supermarkets are now a step closer to a price war. Citi observes the gap with Coles in supermarkets is still widening and as management is reviewing the store portfolio some closures may occur in both supermarkets and Big W.

The valuation now looks stretched in Morgan Stanley's view and concerns over the Big W deterioration and further price investment are increasing. Big W has undergone a dramatic reduction in profitability since FY13, the broker observes, and the weak performance is expected to continue until the second quarter of FY17.

For FY17, Morgan Stanley calculates the headwinds from extra investment at 30 basis points and operating de-leverage from flat like-for-like sales growth at 60 basis points. Hence the trough Australian food & liquor margin is estimated at 4.1%. The broker retains an Underperform rating, expecting earnings downgrades will continue, while the shares are discounting a recovery that is likely to be long dated.

FNArena's database has one Buy (Credit Suisse), three Hold and four Sell ratings. The consensus target is $20.60, suggesting 1.8% downside to the last share price. This compares with $21.36 ahead of the update. Targets range from $17.00 (Morgan Stanley) to $25.85 (Credit Suisse).
 

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