In case you missed my deep dive on Woolworths Limited (ASX: WOW) a while back, here's a slightly refreshed version.
Woolworths has been under pressure from many directions, with some shareholders reportedly even asking for previous chairman Roger Corbett to return.
And management have admitted that they've made mistakes with the supermarkets as well as with the rollout of hardware brand Masters.
Fierce competitor Coles – owned by Wesfarmers Ltd (ASX: WES) since 2009 – has clocked up consistent same-store-sales growth above Woolworths for many quarters. And while Coles was coming off a low base, the retailer continues to generate strong growth while Woolworths appears lucky to post any growth these days.
Here are some of the challenges that Woolworths' management need to address, particularly in regards to the Australian Food and Liquor division.
Change focus from margins back to customers
You can see from the chart below, that Woolworths Australian Food and Liquor earnings before interest and tax (EBIT) margin is significantly higher than Coles, so clearly Woolworths has room to cut back its margins – and will likely need to, to be able to compete on price with the likes of Coles and particularly with lowest-price competitors Costco and Aldi.
Source: Annual reports
Customer satisfaction levels aren't great either, particularly in the Fruit & Veg section, but it's not the only section.
The problem Woolworths faces there are that cutting back margins will likely mean a fall in net profit, return on equity, earnings per share and potentially dividends which would see the current share price fall dramatically. Can management drive stronger growth without hacking at earnings margins?
The company says it has identified $500 million in efficiencies, will reduce complexity and shrinkage and implement further cost improvements. Woolworths also says it is investing capital into the supermarkets while reducing Masters' investment until it can prove the model.
A picture tells a thousand words?
As EBIT margins have grown, Woolworths' sales per square metre have stagnated while Coles' continues to soar.
Source: Annual reports
That may well be due to a lack of refurbishments of existing stores over the past few years. Coles has clearly refurbished more stores than Woolworths since 2011.
Source: Woolworths Presentation
Many analysts and investors are also worried about the rise of discount supermarket retailer Aldi. Aldi specialises in a limited range of products, but at super cheap prices.
Price not only factor
But price is not the only factor influencing consumers where they shop. 45% of Woolworths' sales comes from premium customers, with just 21% coming from budget customers and the remaining 34% from mainstream customers. In simple terms, that suggests that nearly 80% of Woolworths' sales comes from customers who care less about price than other factors.
In fact, location and convenience represent the biggest driver consumers consider when choosing where to shop. If a Woolworths store is closer, chance are consumers will shop there, and with 1.2x more stores than Coles and great locations near its customers, there's a good reason why Woolworths has 1.4 times more sales than Coles.
Price and value represent one-third of importance, with other factors including, range, shopping experience, service and inspiration being other primary factors.
Is Woolworths the next Tesco?
Many investors have compared the demise of UK supermarket Tesco to Woolworths, but the differences couldn't be starker. Some have suggested that Woolworths' margins could halve like Tesco's, but that appears most unlikely – given Coles' margins are already above the half-way mark, and the differences as below.
Here are just some of the major differences:-
- Tesco has four different format stores, compared to Woolworths' one.
- Deutsche Bank recently noted that population growth in Australia is 3 times that of Britain while new store growth has been lower here.
- The UK has 4 major chains including Tesco, Morrisons, Sainsbury's and Asda (5 if you include high-end Waitrose), so is more competitive.
- Tesco persisted with expansion into the US for several years, finally admitting defeat in 2013 and taking a £1 billion write-down on its investment. Did Tesco take its eyes off threats in its home market over that period? Clearly yes.
- Tesco tried to focus on the budget customers with "cheap and cheerful" products, exactly the type of customers Aldi and Lidl were targeting.
- Like Woolworths and Coles, Tesco doesn't just do supermarkets. It also has financial services including loans, data processing, restaurants and operates in 12 different countries.
- Tesco has $20 billion worth of property on its books – unlike Coles and Woolworths who sell off and lease-back their store properties.
- UK supermarkets expanded rapidly into out-of-town hyper and 'super' supermarkets, away from their customers, allowing Aldi and Lidl to move in where the customers were.
- Tesco was also forced to write down £800 million on property it had bought for out-of-town hypermarkets that it now won't develop.
- While Tesco has lost market share, the combined market share across the 4 UK retailers has remained steady for many years (over 75%), with Sainsbury's and Waitrose gaining at the expense of Tesco and Morrisons.
Another major factor is changing consumer behaviour. In the UK, people are opting for a bulk online order for key staples and then topping up during the week for fresh produce. Who's going to visit those hypermarkets out-of-town mid-week? Clearly, Coles and Woolworths don't have that issue, it being convenient to shop at their stores during the week.
The other factor that Woolworths and Coles could adopt, which the UK retailers are already doing is taking the "if you can't beat them, join them" route, and introducing budget, limited product stores to compete head on with the likes of Aldi and Lidl.
Mastering hardware
In regard to Masters, Woolworths says it is bringing out a new range and store format, and given the current fragmentation, there is plenty of opportunity for Woolworths to get Masters right. Working on getting the existing model right before expending loads more capital on the stores is also clearly a good move.
The other good news is that Home Timber and Hardware makes up about half of Woolworths' Home Improvement sales, and generates positive earnings. That allows Woolworths time to focus more on getting Masters right. Clearly they need to make Masters more like Bunnings and less like Masters.
Could the company rebrand Masters as Home Timber and Hardware? That's a possibility too.
Despite the view of detractors, I believe Woolworths can get Masters to a similar stage as Bunnings, with a market share of around 20%. As a long-term investor and shareholder, I certainly hope that Woolworths doesn't give up on it yet.
The verdict on Woolworths and its 5% fully franked dividend yield
Woolworths still has a leading market share, 20% more than its nearest competitor, Coles. And it serves a staggering 14.6 million customers 1.3 times each week on average. More than 500,000 customers shop online each week and Woolworths has more than 50% online food market share, so it seems the company is doing some things right.
But Woolworths may see some compression of its margins as it reinvests savings back into its store network as refurbishments and refocuses back on consumers. That may see profits fall in the short term, and could take dividends and the share price with it.
But that's not a certainty and Woolworths may well manage to get back on track without sacrificing margins and all the while paying out a lovely fully franked 5% dividend yield.
My guess is Woolworths can at least maintain their dividend during this period of reinvestment and transition.
At around $28, the shares trade on a P/E of around 14 times earnings. That modest valuation should put some sort of floor under the share price.
For investors today, Woolworths is no longer the growth story it was.
Today, it's an income play, and a pretty good one at that given its 5% fully franked dividend yield, which grosses up to 7.1% when franked credits are taken into account. In today's low interest rate environment, and given Woolworth's strength as a business, it's a return that's hard to beat.
