Woolworths: Oh Lord, I Have Sinned

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

Analysts agree Woolworths had lost its way, thus welcoming cost-out plans and a portfolio rethink following a weaker than expected first half.

-Woolworths earnings disappointed
-Impact of Victorian strike underestimated
-Cost of living crisis drives value-seeking from shoppers
-Management responds with overdue action

By Greg Peel

It was a rough first half for Australia’s largest consumer wallets-exposed conglomerate. Woolworths Group’s ((WOW)) earnings fell by a greater than expected -4% year on year, despite revenue growing 4%. Underlying profit was down -21%.

Analysts had underestimated the one-off impact of 17 days of industrial action at Woolworths’ Victorian distribution centres and resultant incremental supply chain commissioning and dual-running costs. The disruptions were another in a series of concerns for the supermarkets and Woolworths in particular, Macquarie notes, with the ACCC Inquiry and other negative headlines creating an overhang in recent months.

This at a time in which customers remain highly value-conscious amidst the cost of living crisis, driving value-seeking, trading down to own-brand and lower priced goods, and cross-shopping to seek better prices at rivals Coles Group ((COL)) and in particular, Aldi.

Within such context, management has emphasised its focus on improving the shopping experience, highlighting price perception, trust and product availability. In particular, management called out investment in price and promotion, noting it had recently absorbed price increases in some categories such as meat.

This, in addition to other trading-down pressures, continues to impact profitability of the key Australian Food segment, with guidance implying an underlying -2% year on year decrease in second half earnings, Macquarie notes.

Woolworths’ earnings margin was down -90bps to 5.2%, impacted by the one-off impact of industrial action, supply chain commissioning and dual-running costs, price and promotional activity, higher meat input costs, customers shifting towards lower-priced items and specials, wage increases, and a negative mix-shift due to higher eCommerce sales. This long list was partly offset by productivity initiatives, Ord Minnett points out.

The only good news was better than expected performances for both B2B and New Zealand Food. However, perennial disappointment Big W is expected to be loss-making in FY25.

The first seven weeks of second half trading showed Australian Foods revenue up 3.3% year on year, but second half earnings are to decline by mid-single digits, inclusive of supply chain commissioning and duplication costs.

Back to Basics

Woolworths has the number one market share, one of the best supply chains and the most advanced data capabilities in the market. In Jarden’s view, these are not being leveraged to drive outcomes effectively.

In recent times, management has not been focused on the simple maxim of giving its supermarket customers the product they want at a good price, Ord Minnett believes, but on forays into other retail segments.

To that end, brokers are relieved management will pursue -$400m of cost savings.

Citi notes that under the prior CEO, Woolworths executed a -$500m cost-out program around 2015. Much of this was re-invested into price and service at the time to arrest prolonged market share losses. While the rebase process was painful, the strategy proved successful.

The circumstances now are not as dire as that period so Citi does not advocate a material rebase. However, the broker does see similarities in that ultimately revenue growth needs to be higher to drive operating leverage. Though cost savings may help achieve this, Citi suggests more will be needed to win customers back.

Investors have sought the pursuit of cost savings and greater focus on return from funds engaged (ROFE) from Woolworths’ management for some time, UBS notes. There is potential to reduce costs as, while Woolworths booked 1.6x greater sales and earnings in FY24 than Coles, it has twice the headcount of Coles above store level.

Cost-outs will concentrate on the back office.

Goldman Sachs believes a refocus on execution basics and productivity could drive improvement in consumer sentiment post the ACCC Inquiry, as well as improved funding to help a market share recovery and Retail Media.

The supermarket giant appears to have seen the light, Ord Minnett suggests, by unveiling its plan to strip -$400m in costs out of the company. New management’s tighter focus on expenses creates a crucial variable in an industry characterised by thin margins and low sales growth relative to other sectors and thus is a very positive development, in Ord Minnett’s view.

Re-investment of costs saved will be dependent on market conditions. Macquarie expects a large portion of these will be allocated to initiatives to improve customer perception and offset cost inflation before translating into earnings.

Portfolio Rethink

Alongside cost-outs, Woolworths will conduct a portfolio review, likely to focus on the low ROFE divisions of Big W and New Zealand Food, UBS suggests, and a more critical view of the profit and ROFE potential of currently loss-making new businesses such as MarketPlus and Healthylife.

Future updates on Big W and NZ Food are likely, Macquarie believes, as Woolworths reviews the long-term opportunity, with potential for right-sizing or potentially an exit.

Highlighting the problem is the W Living segment, Ord Minnett notes, made up of Big W, Petstock and other smaller businesses. W Living generated revenue of more than $3bn from its operations in the first half, but a “paltry” $15m in earnings.

It’s unclear whether a divestment of NZ Food would be contemplated considering the rebrand to Woolworths. But Citi expects there would be some investor support for a de-merger (as opposed to an unlikely sale) to allow shareholders a chance to participate in recovery upside. A closure of MyDeal (in the same fashion as Catch) could also makes sense given its lack of contribution, Citi suggests.

Waiting Game

“Will Woolworths use its scale to invest in getting the basics right?” asks Jarden. If so, can it drive share of wallet and leverage its superior data/adjacency opportunities? “Can Woolworths bank some of the -$400m cost-out? Can management work the assets harder to drive return on invested capital?”.

Capex will be at the lower end, and Jarden thinks yes. The broker retains an Overweight rating but notes improving share gain is needed to drive near-term outperformance, which will likely take time. Jarden’s price target rises to $37.00 from $36.70.

Goldman Sachs reiterates its Buy rating, seeing early signs of a refocus on productivity and increased precision execution driving promotional effectiveness. Goldman has a target of $36.10.

Among the seven brokers monitored daily by FNArena covering Woolworths, only Morgan Stanley and Ord Minnett have a Buy-equivalent rating. Everyone else is on Hold. Morgan Stanely’s rating is called Overweight, with a $34.10 target.

Ord Minnett suggests Woolworths “still has plenty” but better execution of what should be a relatively simple business model will go a long way to improving earnings and returns to shareholders. This broker takes a more constructive view on the stock given management’s targets for savings and efficiency gains, and upgrades its recommendation to Buy from Hold.

Among the Hold or equivalent raters, Morgans is of the view that Woolworths is a good, defensive business with dominant market positions and long-term earnings tailwinds from population growth and leveraging its scale advantage.

In the short term, however, margins remain under pressure from customers shifting to lower-priced items and buying more products on special, higher costs (including wages), and a negative mix-shift due to higher eCommerce sales versus in-store.

With subdued earnings growth expected, Morgans sees the stock’s current valuation as full.

UBS equally retains its Neutral rating despite another earnings downgrade in Australian Food and Big W as the new focus on costs and portfolio ROFE suggests a possible path to improved performance. UBS notes the PE gap to Coles is significantly below its historical average.

Bell Potter points out that, following the recent share price correction, Woolworths has traded down to a comparable enterprise value to earnings multiple to that of Coles, “which does not look unreasonable”.

A trend has developed here that suggests the share price correction has saved Woolworths from potential Sell ratings.

Macquarie expects regulatory oversight and margins to remain an overhang, but with the group having benefits of scale and a strong store network, the current PE, -10% below the long-run average, may create an opportunity once downside risk to earnings has passed.

Citi sees some downside risk to consensus earnings lingering over the next few periods as Woolworths fights to regain momentum in Australian Food. Citi retains a Neutral rating on the basis that the cloudy earnings outlook is probably reflected in the share price and market positioning.

The average target among the seven brokers has fallen to $31.82 from $32.14, on a range from $30.50 (UBS) to $34.10 (Morgan Stanley).

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.

FNArenais proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms