Supermarket behemoth Woolworths Limited (ASX: WOW) has endured a disastrous run over the last 12 months and the situation finally came to a head last week, with CEO Grant O'Brien admitting defeat upon the group's second profit downgrade in just four months.
As it stands, Woolworths now expects net profit after tax (NPAT) before significant items to be in line with the $2.45 billion achieved during the 2014 financial year (FY14), although NPAT after significant items will be approximately 12% lower at $2.15 billion.
Here are three key issues facing the business…
Masters
Woolworths took an enormous gamble on Masters which it hoped would one day compete with Bunnings, owned by primary rival Wesfarmers Ltd (ASX: WES). Woolworths and its home improvement partner, Lowe's Companies, have pumped billions of dollars into the venture and although it has recorded strong sales growth more recently (arguably due to the opening of new stores), the operation itself remains heavily cash flow negative.
To make matters worse, O'Brien (the outgoing CEO) has long been promising improved results from the business line. In May 2014, he insisted Masters would be profitable by 2016 before disappointing the market in August, revealing it would not breakeven until at least 2017. Even that target seems too optimistic, with a more reasonable objective being a breakeven result in 2019.
Personally, I don't believe Woolworths should give up on the Masters venture just yet. It is bringing out a new range and store format which has yielded positive results thus far, while it has also pumped the breaks on the business' expansion and promised to revert its focus back to its core supermarket division (more on that below). In the long term, Masters could still prove to be a master stroke by Woolworths.
Supermarkets
While Masters is acting as a huge drag on the group's overall performance it isn't the biggest issue facing Woolworths. Woolworths' management was so eager to drive the new home improvement arm that it took its focus away from its core operations, being the supermarket division.
Typically, the company with the highest margins will emerge as the dominant force within an industry, but not when those margins are a result of uncompetitive pricing. Woolworths has heavily prioritised margins over market share, and that is now coming back to haunt them with Coles and German discount retailer Aldi recording strong and consistent same-store sales growth. This is a huge issue for Woolworths, and one that will need to be addressed as soon as possible by management.
The fear amongst investors is that a cutback in margins will have a huge impact on earnings, which is a justifiable concern given that Woolworths' Food and Liquor division accounts for such a huge chunk of the group's overall earnings.
However, management has also identified $500 million in efficiencies and other cost improvements (including a reduction in staff numbers) which should help offset the impact on margins. At the same time, they will focus on delivering those savings back to customers (e.g. better prices and shopping experiences) which should help bolster market share.
Management
In light of the enormous headwinds facing the business, many investors and analysts have called for a complete management overhaul. That's likely why the market reacted so positively after the announcement was made that O'Brien would depart the business last week after less than four years in the top job. Many would also like to see the board cleared out and started afresh.
Management has openly admitted their mistakes in the running of the business and have highlighted a number of strategic initiatives they plan to undertake to improve the long-term returns for shareholders. As previously mentioned, one of the key initiatives is to lessen the focus on margins and ultimately improve the customer experience. It will pump more than $500 million into this initiative whilst also rolling out new stores and revamping existing ones and reducing overall headcount.
Upon his departure last week, O'Brien said that "the recent performance has been disappointing and below expectations. I believe it is in the best interest of the Company for new leadership to see these plans (the strategies outlined at Woolworths' recent investor day) to fruition."
O'Brien will remain as CEO until a replacement can be found, with internal and external candidates being considered for the role. Personally, I think a change of leadership is just what Woolworths needs right now.
Should you buy?
There are a number of question marks hanging over the future of Woolworths, which is one of the reasons the stock has been sold off so heavily over the last 12 months. Although it is by no means a risk-free bet, I believe Woolworths could be a great pick-up for long-term investors at its current price tag whereby investors could consider a slow and progressive entry into the stock in case it does have further to fall in the near-term.
As it stands, the shares are trading within 2.3% of a three-year low at just $26.86, and offer a compelling 5.3% fully franked dividend yield (7.6% when grossed up for franking credits).
