Woolworths argues it has moved on from turning around the business to transforming the business for growth, and there were indeed impressive achievements and milestones in the 2017 result. Should you buy the stock? Maybe, but not above $24. Woolworths is becoming as well-managed as at any time since the glory days of the 1990s and there should be a solid management premium in the share price but at $26 the 2018 earnings multiple is 20 times, which is too high given the remaining problems ahead. In particular the market is too optimistic on profit margins. At $24 the multiple is a more appropriate 18 times.
CEO Brad Banducci and his team are doing an excellent job but they inherited a huge organisation with so many problems that it will take more time to fully derisk Woolies. The market, in marking the stock down from its pre-result high of $27.75, already sees this. To justify $26 everything has to go right but there is more disappointment ahead and we think you will get a better price.
One of the result’s highlights was same-store sales growth in the June quarter of 6.4 per cent. This compares with 3.6 per cent for the full 2017 financial year, so the acceleration through the year is clear. The recovery began in the September quarter last year after consecutive quarters of falls in same-store sales, driven by perceptions Woolworths was uncompetitive on price and customer fatigue with the fleet of dated, tired stores. But shoppers have returned to Woolworths, reflected in accelerating growth in comparable transactions and stronger internal measures of customer confidence in the brand. Items per basket have also resumed growth.
Attracting customers back to the supermarkets has however come at the very high cost of over a billion dollars in price cuts to restore shoppers’ trust Woolworths will be price-competitive with Coles and Aldi. Unfortunately there is more profit margin compression to come as electricity costs surge and Woolworths comes up against internal limits to how far it can boost margins by reducing shrinkage (lost, spoiled, incorrect and stolen stock). To reduce shrinkage beyond a certain point stores would have to be starved of some inventory, which would cause more stock-outs and alienate customers. And while price competition has abated for the moment, we think it will return as Coles addresses its inferior same-store sales growth of just one per cent in food & liquor in 2017.
Same-store sales will also slow through fiscal 2018 due to the high base created by the successful relaunch of the loyalty program in September 2016. Historically Woolworths’ share price has been correlated with the rate of same-store sales growth, suggesting downwards pressure on the stock in coming quarters – especially as the premium earnings multiple already creates a roof for the share price.
Big W’s serious problems and financial losses have worsened to become a burden and distraction for management. The 2017 loss was over $150 million, higher than guidance of $115-135 million in May. Management admits the problems with Big W are fundamental and go to core processes. Shoppers do not trust Big W will have the range of products they want at competitive prices – though early experiments prove they respond well to better offers. To us this sounds like more heavy discounting lies ahead similar to what it took to restore customer confidence in the supermarkets. Meanwhile, Big W’s lease obligations are onerous and long-term. Big W cannot simply close unprofitable stores, as this would require not only paying out the lease but in some cases also compensating the landlord for lost foot traffic to nearby specialty stores.
Unfortunately Big W will still be only in the early stages of its turnaround in 2018, just as Amazon starts to take share from legacy discount variety brands. It is possible Big W will never make a profit again. Near term the 2018 loss could be as high as 2017. The business is not saleable in its current condition.
There are other headwinds, for example higher depreciation expense in Food as capital expenditure tilts towards assets with shorter lives. The challenge and opportunity for management is to offset more losses from Big W with earnings growth in food & liquor. This is achievable but everything will have to go right for the group, and our contention is this best case is already in the share price – a reality which does not sit comfortably with management’s reluctance to provide earnings guidance for 2018. A wide range of earnings outcomes is possible.