With interest rates expected to be 1.5% in a year's time, many investors are understandably seeking higher yielding stocks to make up for lost income on cash balances. The likes of Telstra Corporation Ltd (ASX: TLS) and Wesfarmers Ltd (ASX: WES) have been popular choices and with Woolworths Limited (ASX: WOW) yielding 4.7% versus 4.2% for the ASX, it may also appeal to yield-hungry investors at face value.
Financial strength
In terms of its balance sheet, Woolworths is a sound business in my view. It has a relatively low level of gearing, with net debt to equity standing at 33%. This indicates that Woolworths is able to increase borrowings at a time when interest rates are low so as to maximise its return on equity, which stood at 19.7% last year.
However, Woolworths' cash flow is less impressive in my view. For example, in its half-year results Woolworths recorded a fall in net operating cash flow of 16.9% due mostly to challenging trading conditions. And while it reduced capital expenditure by a small amount from $558 million to $541 million, Woolworths increased dividends paid. In fact, they rose by 2.6% and when combined with the fall in operating cash flow, it means that Woolworths' free cash flow was insufficient to make its dividend payments.
In my view, this does not bode well for Woolworths' dividend outlook since the current situation is unsustainable. Even in the last full-year, Woolworths spent 85% of its free cash flow on dividends. And when property development costs of $595 million in financial year 2015 are factored in, it is clear that borrowings or profit may need to rise in order to fund even a reduced future dividend.
Strategy
Woolworths' strategy is also somewhat mixed. On the one hand, I feel that its investment in areas such as customer service and improving the in-store experience are sound moves. These changes should improve customer loyalty towards Woolworths and help the company to retain and even expand its economic moat, which may aid margins further down the line.
Similarly, I'm in favour of Woolworths' recent decision to cut costs via an updated operating model. For example, it will cut 500 jobs from its support office and supply chain, as well as slow growth of its supermarket rollout programme in order to focus on existing stores.
However, Woolworths has also invested $350 million in lower prices since H1 2015, with the company recording an average price deflation of 2.1% in H1 2016. In the long run, this may boost sales, but profitability and cash flow will inevitably suffer, meaning there is likely to be additional pressure on a dividend which already seems to be unaffordable. The strategy to compete with the likes of Coles, Aldi and Lidl then is yet to be proven and remains a risk for investors.
