Mike King, 29 October 2015

The full scope of Woolworths Limited’s (ASX: WOW) problems were revealed in the company’s first quarter sales report.

From running on all eight cylinders a few years ago, the retailer now faces issues in many of its businesses. Here’s a brief summary…

  1. The group as a whole expects to see its first-half profit fall between 28% and 35% compared to the corresponding period last year. Woolies is predicting net profit after tax of between $900 million and $1 billion. In the 2015 financial half year, the retailer posted a net profit of $1,280 million (which was 3% lower than the same period in 2014).
  2. The core Food and Liquor business saw sales rise 0.4%, but same-store-sales were down 1% for the quarter. Clearly, consumers are switching to Woolworths’ competitors, including Coles – owned by Wesfarmers Ltd (ASX: WES), IGA stores – backed by Metcash Limited (ASX: MTS) and discount retailers Aldi and Costco.
  3. General Merchandise – which is Big W – saw sales plummet by 7.9% and same-store-sales were down 8.1%. The discount variety store is struggling against renewed competition from Wesfarmers-backed Target and Kmart. Both Kmart and Target posted strong gains in sales, up 12.5% and 3.1% respectively in the September quarter.
  4. Masters and Home Timber and Hardware are still posting strong growth in sales at 23.5% and 17.1% respectively, but the former is likely still making a loss. Home Timber and Hardware is profitable at the earnings before interest and tax (EBIT) level, unlike its stablemate Masters.
  5. Petrol sales were down, in terms of both litres sold and dollars by 20.3% and 27.9% respectively. That was partly due to a change in how sales are recognised at Caltex operated sites.
  6. The two bright spots are New Zealand supermarkets and Hotels, which posted decent sales growth.

What every investor wants to know is how Woolworths’ management are going to fix these issues. Media reports suggest Big W and the Home Improvement (both Masters and Home Timber & Hardware) division could be up for sale. Caltex Australia Limited (ASX: CTX) has also been reported to be considering buying out its partner Woolworths in their petrol joint venture.

Food and liquor

The key issue with the core supermarkets business is that management drove margins too high, and consumers have responded to higher prices by shopping elsewhere. Last financial year, Woolworths’ Food and Liquor division had an EBIT margin of 7.9%, compared to 5.4% for Coles.

To bring the shoppers back, Woolworths has no choice but to lower prices, which will negatively affect its bottom line (net profit). So far, that’s what the company has been doing, investing in price, service and customer experience, but it’s not going to fix the problems overnight.

It took Wesfarmers some time to turn around Coles after it bought the supermarket retailer back in 2007 for $19.3 billion. It wasn’t until 2009 that Wesfarmers saw Coles’ EBIT margins begin to rise.

Big W

Management says they are making progress and sales trends improved in October and they expect that trend to continue during the second quarter. But it’s hard to see this ship turning around anytime soon too. The good news is that if Wesfarmers can do it with perennially struggling Target and Kmart, there’s no reason why Woolworths can’t do the same with Big W.

Home Improvement

Woolworths says that new format Masters stores continue to exceed sales per store of those in the original format by more than 30%. By the end of June 2016, around half the network of stores is expected to be in the new format.

Home Timber and Hardware seems to keep purring along, and I’ve suggested more than a few times that Woolworths should dump the Masters brand for Home Timber and Hardware.

While many analysts (and shareholders) want Woolworths to dump the Home Improvement business, I’d prefer for management to persist with it. The home improvement market is huge – especially when you consider the largest player Bunnings has just under 20% of the market.

Foolish takeaway

Woolworths’ management say there is ‘still much to do’ and they’re not wrong. Lowering prices and cutting their margins in the food and liquor division is essential, but will result in lower profits, earnings and likely a lower dividend. Similar margins to Coles would see EBIT fall by around 30%.

I’d be very surprised to see any divisions sold off in the short-term unless someone offered a ridiculous price for them. What I see as more likely is someone making a bid for all of Woolworths, pretty much like Wesfarmers did with Coles in 2007.

Extracted in full from The Motley Fool.