-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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-Aldi will weigh on market share
-Independents appear to be coping
-Metcash supporting the sector
 

By Eva Brocklehurst

In the wake of Aldi's incursion into South Australia, which commenced last month, Metcash ((MTS)) and its independent grocery retailers appear to be holding the new entrant at bay. Aldi is expected to move into Western Australia later this year.

While early days, Citi does not expect Aldi's success to do much more than remove 1.0% of annual sales from the Metcash group. Metcash supplies a variety of retailers in Adelaide but its network remains quite intent on closely meeting customer needs and emphasising the fresh component of their offering.

Metcash supplies Foodland and IGA stores with food & grocery, liquor to the Cellarbrations outlets and hardware to its Mitre 10 network. South Australia is an important state as Metcash has a higher food & grocery market share here compared with the national average.

Aldi is instigating a rise in price discounting across the sector, thereby reducing industry margins, Ord Minnett observes, but Metcash provides a broad role to its retailer network, as a box mover with significant sales and in-house purchasing functions as well as store refurbishment programs.

Brokers toured Adelaide stores recently and evaluated the specific efforts being made to improve the offer to customers in advance of Aldi's presence. They note these efforts appear to have gained some traction.

While market share losses and price investment are occurring, and this should likely weigh on sales growth and gross margins, Ord Minnett suggests all the losses are not likely to accrue to Metcash but rather be spread across existing market share. In other words, Coles ((WES)) and Woolworths ((WOW)) will also wear some of the impact.

Moreover, the broker believes the expansion of Aldi has been well incorporated into market estimates. Ord Minnett notes that initial price discounts by Aldi were significant, but the impact is moderating as the level of aggression in price is cooling.

Deutsche Bank observes that whilst there are only eight Aldi stores currently in operation in SA, the launch has been intensively marketed. The worst declines for the IGA stores was in the first week before moderating somewhat.

The visit served to remind the broker that independents have a strong position in SA, with the Foodland brand resonating will with consumers. This should position them well to defend against Aldi's roll-out in that state compared with the eastern seaboard.

Still, while the impact from the initial stores may settle down, the roll-out of Aldi will be rapid and this could worsen the decline. The broker believes Metcash has been obtaining a benefit from the struggles at Woolworths and this is likely to eventually turn into a headwind.

As an addendum to the SA site tour, Deutsche Bank notes some discussion around the potential for a merger between Mitre 10 and Home Timber & Hardware. Metcash management believes there a distinct complimentary fit in this, as well as potential to improve the operations of Home Timber & Hardware as it has lower margins than Mitre 10 stores.

Also, Deutsche Bank notes, the implementation of the effects test, as recommended by the Harper Review and endorsed by the government, could allow the courts to decide how much a retailer's conduct increases competition versus any lessening. It remains unclear whether this effects test will be passed by parliament but, on balance, this could be positive for Metcash and could make in harder for Coles and Woolworths to open new stores, the broker maintains.

Credit Suisse also does not expect the impact of Aldi to be a significant drag. The broker believes the independents' approach has been well thought out, strengthening their position in fresh food, refurbishing stores and elevating service levels. Nevertheless, experience in the eastern states suggests to the broker that the impact on customer traffic becomes more negative as Aldi's network increases.

There appears to have been some aggressive pricing by Aldi, particularly in regard to produce, and this has had a consequent impact on retailer profit. Credit Suisse believes this is a long-term issue for both the retail sector and Metcash.

The broker expects the negative sales impact will accelerate in FY17 but Metcash appears to be willing to support the sector through better costs, which suggests that wholesale deflation will accelerate.

There is no average store in the sector, making generalisations difficult, the broker adds. While upgrading to premium stores is working for some, the broker does not believe this is the panacea for all. Credit Suisse maintains Metcash could do more to align pricing with the requirements of the value stores.

There are two Buy, three Hold and two Sell ratings for Metcash on FNArena's database. The consensus target is $1.61, suggesting 8.0% downside to the last share price. Targets range from $1.05 (UBS) to $2.05 (Citi).

Note also that Metcash is, according to the most recent ASIC data, the second most shorted stock on the ASX at 17.6% [See The Short Report].

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-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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