Summary:

  • The Woolworths turnaround will turn but will take so long there are better investing opportunities elsewhere in the meantime.
  • The stock is only worth about $23.20 even after factoring in the benefits of the turnaround. This is in line with current prices.
  • Our model portfolio sees better opportunities in the mid-cap market.
  • The higher share price since the announcement two weeks ago reflects short-covering after previous heavy shorting. There is also relief management is doing something the market recognises from the turnaround playbook: rebase earnings, slash costs, step back from excessive growth to a focus on profitability.
  • Profit taking after the rally over $24 reflects the lack of current value in the stock and, we suspect, a convergence of market views towards our thesis, which is Woolworths is being turned around but the upside is limited to the outcomes of better management. The company’s external environment remains hostile due to the food price deflation and would get worse if German discounter Lidl enters Australia.

 
The Woolworths turnaround will turn but it will take so long there are better investing opportunities elsewhere in the meantime. Having bought the stock around $21 for our model portfolio we now plan to ease out of the position around $23.50 to make room for the undervalued small and mid-cap names we’re finding. Rather than hold the stock through the expensive, dilutive turnaround ahead we would prefer to buy it back around $25 on the way out of the turnaround.
This is our conclusion after a detailed review of Woolworths post the recent $959m of impairment and restructuring charges. Our experience with large-cap ASX turnarounds gives us confidence the company will emerge better-managed than during the recent years of strategic failure, but the problem this time is the likely competitive response by Coles and Aldi. Most likely Woolworths will have to continue cutting prices to win customers back after the widespread perception developed in recent years that Woolworths is expensive. There is further margin pressure to come.
There is also the serious threat of even more competition from Lidl, Aldi’s rival discounter in Germany. Although Lidl denies it plans to open in Australia, it is known to be talking with suppliers and has researched sites for a possible distribution centre in Melbourne. Lidl is a ‘lights out’ risk for supermarket investors in Australia because its entry would cause another round of damaging margin compression as stores fight to retain market share. It’s becoming a better time to be a supermarket shopper than investor.
Woolworths’ higher share price since the announcement two weeks ago reflects short-covering after previous heavy shorting. Profit taking after the rally over $24 reflects the lack of current value in the stock and, we suspect, a convergence of market views towards our thesis, which in Woolworths is being turned around but the upside is limited to the outcomes of better management. The competitive environment remains hostile.
The higher share price also reflects relief management is doing something the market recognises from the turnaround playbook: rebase earnings, slash costs, step back from excessive growth to a focus on profitability. Woolworths will be a smaller, more profitable business. Scheduled net new store openings over the next three years have been cut from 90 to 45 by closing underperforming stores and cancelling some new stores. Capital expenditure will be reallocated to refurbishment of existing stores. Early trading performance in refurbished stores so far is “very encouraging” according to management. 2018 should be a better year for same store sales as the refurbished stores improve.
WOW could be summarised as a slow-growth turnaround with a credit rating problem because keeping the investment-grade credit rating, a stated priority, comes at the cost of slower growth. The flat margin outlook and 2016’s large loss probably leave little room between the current ratings of BBB/Baa2 and BBB-/Baa3. Another reason for the tightening in capex spend is because the constrained credit metrics don’t leave enough room for capex on existing stores and the former number of planned new stores as well. Asset sales are probable (EziBuy, the petrol business, even Big W?) and underwriting the dividend reinvestment plan (DRP) was flagged.
We would suggest divesting Big W. 52 years after it opened in 1964, Big W is yet to settle on how to differentiate itself from Kmart and Target. We do not understand the perennial fixation on keeping Big W. It has not been a consistent, adequate performer for over a decade.
The previous headlong rush to open new stores and grow Masters rather than maximise the appeal of existing stores continues to take its toll. Underwriting the DRP would be a stiff headwind for the share price. Why not just omit the dividend for a while? When a dividend is fully underwritten a company issues new shares to the value of the dividend, which dilutes earnings per share and return on equity. Raising enough equity, in this way, to fund the refurbishment of Woolworths’ ageing stores compresses our valuation to just $23.20.
We’re told this is a three to five year journey, so our valuation is based on an estimate of what profitability could recover to after then. The valuation is around current prices, so the stock is already pricing in a recovery years from completion. The 2017 price-earnings ratio of 19 times also prices in a recovery and is at a significant premium to the market at 16 times. This is not a cheap stock despite the share price downtrend since early 2014.
The thought of not having Woolworths in the portfolio will be confronting to investors used to owning large companies because they are large. But no investor needs supermarket exposure for the sake of it and there are shorter-dated capital growth plays than Woolworths. Holding this stock will require deep patience; there is no quick fix here.
QBE’s turnaround comes to mind. This took longer and cost more than the market expected at any point in the early stages. There was much disappointment along the way.
Originally published in The Australian, Friday 5th August
David Walker is a senior analyst at Clime Investment Management. Disclaimer: Clime Asset Management owns shares in Woolworths.