The first stage of the Woolworths Limited (ASX: WOW) turnaround is over. That was when the company was "in a mess, and they didn't recognise it." Now, the company is "definitely making some progress operationally", and the shares are rising to show for it. But that mightn't be enough to warrant buying the shares just yet.
That is the view of Jack Lowenstein and Chad Slater of Morphic Asset Management, according to The Australian Financial Review. They argue that, although Woolworths itself may be improving, the outlook for the industry is not.
Woolworths has been forced to invest in reducing prices across its stores in recent years in order to improve foot traffic and win back market share from Coles – owned by Wesfarmers Ltd (ASX: WES) – as well as Aldi and Costco. It certainly appears to have bridged the gap with Coles, with some signs that Coles may even need to step up its game in order to regain momentum against its rivals.
As quoted by The Sydney Morning Herald recently, Ben Gilbert, an analyst from UBS, said:
"Our channel checks suggest [Coles] management are becoming nervous over slowing like-for-like [sales, excluding new stores], with the risk now being that Coles reacts irrationally (i.e. a step-up in discounting) to minimise the sales loss."
However, although sales growth might be improving, it will come at the expense of margins, which will likely, continue to contract. Where margins settle could be key to valuing the shares, which have rallied more than 9% since hitting a low of $22.34 in early December. The shares are now fetching $24.38, which is 20% above their 52-week low of $20.30.
Another Amazonian Challenge
Woolworths is also facing the prospect of Amazon.com (NASDAQ: AMZN) expanding down under. While companies such as JB Hi-Fi Limited (ASX: JBH), Baby Bunting Group Ltd (ASX: BBN) and Harvey Norman Holdings Limited (ASX: HVN) are vulnerable to Amazon's entry into Australia, the global online retail giant will also look to flex its muscles in the grocery space, potentially threatening Woolworths' sales and margins even further.
Although this isn't an immediate threat – Amazon hasn't begun operations here yet, and it could take some time to really make an impact – Woolworths and Wesfarmers do need to begin preparations. This has been recognised by Wesfarmers' managing director Richard Goyder who, in March 2016, said to the Retail Leaders forum in Sydney that Amazon will "eat all our breakfasts, lunches, and dinners" unless Australian retailers become more innovative and improve their efficiency.
Foolish Takeaway
Woolworths has certainly made improvements across its business that has put it on the right path to recovery. But the company is still facing a number of strong headwinds in an industry that is also facing the prospect of tougher online competition and thinner margins.
Of course, Woolworths could continue to strengthen from here, just as its share price could continue to rise. But there are a number of hurdles the company must overcome to make that happen: personally, I think investors would do better by investing their hard-earned money elsewhere.
