Woolworths Turnaround Requires Patience

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

-Slight progress at supermarkets
-Store closures, fewer new stores
-Concern over credit metrics
-Upside potential when turnaround realised

By Eva Brocklehurst

Woolworths ((WOW)) has bitten down harder on the restructuring bullet, detailing more impairment charges, operational changes and store closures. Brokers generally approve of the strategy to close underperforming stores and open fewer new ones. Nevertheless, the turnaround is expected to take some time to reap benefits.

The company will incur restructuring costs of $959m in FY16, including support functions and supply chain costs. Write-downs in general merchandising total $460m and the division is expected to incur a loss in FY16, with Big W to report a loss of $12-17m and EziBuy $13-18m. Excluding one-offs, FY16 earnings are expected to be $2.55-2.57bn.

Deutsche Bank notes some confusion in the market as to whether the Masters loss is included in the FY16 earnings guidance. The broker previously included home improvement in its estimates but, to avoid confusion, now takes it below the line. A further update on the home improvement segment is expected at the results.

There was also no trading update on June quarter sales but management did suggest there are signs of progress in Australian supermarkets. Yet deflation has intensified and Deutsche Bank notes de-leverage is compounding at least another nine months of price investment. Staff morale and supply chain issues remain significant.

The update is another step forward to reinvigorate the group and Goldman Sachs is encouraged by the new CEO's preparedness to make difficult decisions. The broker suggests comments around incremental improvement in June and July signals price investment could be gaining traction with customers. Still, the industry is highly competitive and any sustainable recovery in food & liquor earnings is unlikely to be evident until late FY17.

Moreover, in recent years Woolworths has been growing its stores faster than its sales, with the result being a declining rate of sale per square metre. The broker notes store closures are aimed at turning this around but, with just 17 stores being closed out of 976, suspects the initial impact will be modest. Goldman, not one of the eight stockbrokers monitored daily on FNArena's database, retains a Neutral rating and $21.50 target.

Ord Minnett concurs, given unrelenting competition in supermarkets, that a turnaround in sales growth in food & liquor, sales per square metre and earnings margin is uncertain and long-dated. In addition the broker remains concerned around the balance sheet and an elevated valuation. Balance sheet risks could arise too, assuming the company takes steps to maintain its BBB investment grade credit rating. Hence, Ord Minnett retains a Lighten rating.

Management's comment that a capital raising is not in its plan, suggests to Morgan Stanley Woolworths will fully underwrite its dividend, given heavy cash outflows in coming years. The broker also points out that this is not the first time Woolworths has hinted supermarket trading has improved and calculates volume growth based on food & liquor sales has actually been positive since the fourth quarter of FY15.

Morgan Stanley lifts FY17 margin estimates to 4.25% from 4.1%, given Woolworths intends to close the 17 stores. Still, even after a modest upgrade the broker still expects a $320m profit reduction in Australian food & liquor in FY17. The broker warns margins rarely rebound after a re-basing and Woolworths now trades at a 26% premium to its global supermarket peers, despite operating with higher margins and more financial leverage.

A $110-180m favourable impact is expected on earnings in FY17 as a result of provisioning for onerous leases, lower amortisation expenses and lower labour costs, yet Credit Suisse does not perceive a level of performance improvement that would justify a valuation upgrade. The broker likes the strategy, while actions taken in supermarkets appear to be stabilising volumes and refurbishments should improve sales growth through FY18.

Still, the broker agrees there is unlikely to be the opportunity to expand earnings margins or market share. The business has the cash flow to implement its restructuring and maintain a 65% dividend pay-out ratio and Credit Suisse downgrades to Neutral from Outperform given the sharp rally in the share price.

Macquarie believes the stock is factoring in a large degree of optimism in its share price. Tentative improvements in customer perceptions at the supermarkets remain some distance from positive comparable sales growth, given the highly deflationary environment, the broker attests. Moreover, volume growth and cost reductions are unlikely to be enough to offset the annualisation of second half poor margin performance in supermarkets.

The restructuring is necessary and Macquarie welcomes the shift to store refurbishment from expansion, as it provides some structural growth drivers beyond the medium term. The broker also agrees there is not much room left in the credit metrics before Woolworths is downgraded.

Shaw & Partners, not one of the eight monitored daily on the database, is also sceptical about the quantum of positive signs, noting this is the slowest growth period for Woolworths in over two decades. Yet, given a valuation of $24, the broker remains comfortable with a Hold rating. Shaw also observes the update incontrovertibly shows Woolworths has been over-earning on margins and top line versus global peers in the past few years, given the returns generated by the supermarkets.

UBS expects the issues the company faces can be fixed over time but the turnaround is likely to take longer and cost more than many expect. The broker reiterates a Sell rating and expects deteriorating trends in grocery will continue. If, and when, the turnaround emerges the broker envisages potential for material upside.

FNArena's database shows three Hold ratings and five Sell. The consensus target is $20.45, suggesting 13.1% downside to the last share price. Targets range from $18.00 (Ord Minnett) to $24.50 (Credit Suisse).
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms