As Woolworths Limited (ASX: WOW) approaches price levels not seen for nearly 10 years, it is worth reviewing whether this once great company and lynchpin of many share portfolios has finally entered into bargain territory.
Woolworths for me has possibly been the greatest investment lesson of my life. Having read the investing styles of both Warren Buffett and Peter Lynch, I thought I was following their lead perfectly. I invested in Woolworths because I understood the business. I shopped there, I live next to a Woolworths store, I even worked there as a young lad.
In my mind the investment was a "no brainer". As I now understand I actually invested without using my brain, I had overestimated Woolworths' moat and the barriers to entry, but for a long while it actually worked out well.
So what went wrong?
In hindsight we now know that Woolworths probably had it too good for too long. Like my middle age stomach, Woolworths grew fat feasting on the juicy Australian grocery market with little competition to speak of. First it was Coles which enjoyed renewed vigour under Wesfarmers Ltd (ASX: WES) and then the arrival of cut price competitors such as Aldi that really saw Woolworths start to suffer.
How is Woolworths responding to the challenge?
To be honest when Aldi arrived on the scene I went into denial along with Woolworths. I fooled myself into believing I had done my research when I visited Aldi's stores. I didn't like the store layout, I didn't want to have to pay for a trolley or pack my own groceries so I readily dismissed Aldi as a serious rival. Woolworths' slow response to Aldi's entry into the market seems to indicate to me they were of a similar mindset.
While initially I dismissed the challenge that Aldi presented, I decided that on the off chance I was wrong (which I usually am), I would look at how Aldi was performing in markets comparable to Australia.
To my surprise Aldi was gaining significant market share in the UK. I also noted that the incumbent grocery chains in the UK had responded to Aldi by slashing prices along with increasing their range of home brands or private labels, a response which had failed to stem the flow of shoppers to Aldi stores.
I started to reassess my investment in Woolworths when they followed the same response to Aldi's threat.
Heavy discounting and increased reliance on private labels actually plays into the hands of Aldi, which Woolworths' management should have been aware of as this approach failed in the UK. The reason being that it reduces the differentiation between the grocery stores and in turn sees a reduction in shopper loyalty.
The future
As investors we know the future is what the market cares most about not the past. So with Woolworths approaching the psychological level of $20 per share (something we haven't seen in almost 10 years) many investors may be tempted into buying Woolworths in the belief it is a bargain at these levels.
While no one can know the future for certain, there remains many worrying signs for Woolworths in my opinion.
Recently UBS predicted that Aldi's share of the grocery market could rise to at least 10% by 2019-20. I believe this is not an unreasonable estimate and could prove to be overly conservative considering Aldi has only just opened its first store in Western Australia and plans to increase store numbers from 373 to 628 over the next four years.
Another more worrying sign for Woolworths and all competitors in the market is that there is another German cut price chain with an eye on the Australian market, Lidl.
While Lidl is believed to have put their Australian plans on hold until after their US roll out takes place in 2018-2019. I find it ironic or perhaps poetic that their foray into the Australian market may actually be brought forward with rumors Lidl are in negotiations to acquire the leases on some Woolworths owned Masters Stores with Woolworths' decision to exit the home hardware market.
Foolish takeaway
As investors I believe it is easy to get caught inside our own circle of knowledge. Initially I dismissed the threat to Woolworths primarily because of its dominant market position, but I failed to take into account the inertia that such dominance can create within a company. I should make it clear I am not proposing the end of Woolworths. I will however be waiting for Woolworths to show signs that they understand their competition better and prove they can hold onto their market share before I consider reinvesting.
