By Paul Rickard

The stock market’s initial burst of enthusiasm to Woolworths appointment of a new CEO has turned out to be a flash in the pan.

Since the announcement before the market opened on 26 February, Woolworths shares have risen from a closing price of $21.89 on 25 February to close yesterday at $22.38. They have also declared a 44c dividend, for a total return of 4.2%. Its main competitor, Wesfarmers, is up over this period from $40.38 to $42.05 and has declared a dividend of 91c for a return of 6.4%, while the overall market has rallied by more than 5.3%.

Woolworths has underperformed. One swallow does not a summer make.

We shouldn’t be surprised that more sober heads have prevailed, because the appointment of a new CEO was just one of the 4 major challenges facing the company, and arguably, the easiest to address. Moreover, new CEOs usually don’t make much impact on a company in the first few weeks. It will take months, if not years, to change the culture at Woolworths, address weaknesses in the leadership team, and deal with the mega issues confronting the supermarket business.

And this comment is not meant to be a reflection on the leadership skills of new CEO Brad Banducci. It is just that Woolworth’s bread and butter, its Australian supermarket business, is in a real pickle.

Supermarket blues

Woolworths supermarket challenges are well known. Firstly, it is facing aggressive new competitors like Aldi, Costco and possibly even Lidl.

Next, it is being thrashed in the sales war by its arch rival, Coles. In the most recent quarter (December), Woolworths comparable store sales in food and liquor fell by 0.6% compared to the corresponding quarter in 2015. In comparison, Coles was able to grow same store sales by 4.9% over this period. 

And things don’t seem to be getting any better for Woolworths. In the first 7 weeks of this year, Woolworths noted is its report that comparable store sales were down 0.9% compared to the same period in 2015.

Finally, and most worryingly, pressure from competitors is forcing Woolworths to cut prices and reduce margin. In fact, the margin collapse has been massive. Gross margin in Australian food and liquor declined by 1.62% in the December half, and with an increased cost of doing business due to more staff hires, the EBIT to sales ratio for the division fell from 7.43% to 5.21%. On sales of circa $50bn, this is a reduction in EBIT of around $1,100m pa.

Still challenges with BigW

Woolworths expresses confidence that its general merchandise division, Big W, may have  turned the corner, following the appointment of a new divisional CEO in Sally Macdonald and a an improvement in its sales performance. 

After a horrific first quarter in which comparable store sales fell by 8.1% compared to the corresponding quarter in 2015, second quarter sales fell by just 1.7%. In the right direction, but still negative growth. In comparison, rival Kmart grew sales by 9.5% in the second quarter, while Target recorded a more modest lift of 0.2%.

Earnings in the half also declined as the cost of doing business increased. EBIT for the division fell from $109.7m to just $67.3m.

The other major challenge that Woolworths faced is what to do with its home improvement business Masters. It has taken the tough decision to close it, which should be a positive for shareholders. Now the tricky job of unwind and exit starts.

Some analysts doubt Woolworth’s claim that “the cash flow impact from a potential sale or wind-up of the business is expected to be broadly neutral to cash flow positive through to completion”. History suggests that business exits are frequently more difficult than anticipated, so I think it may be a little premature to say Woolworth’s pain with Masters is all over. 

Brokers and short sellers still negative

According to FN Arena, the brokers are still negative on Woolworths. Sentiment is -0.5 (on a scale of -1.0 being most negative to +1.0 being most positive), with a consensus target price of $21.42. Interestingly, the range of target prices is Morgan Stanley with a low of $17.00, up to Credit Suisse with a high of $26.13.

Perhaps more importantly, the short sellers are still active and don’t seem in any hurry to close their positions.   According to the latest ASIC figures published on Wednesday, 9.00% of Woolworths shares, or 114.4m shares worth around $2.6bn, are short sold. This is one of the largest positions in the market, and compares to Wesfarmers where 2.89% of its shares are sold short.

While the short sellers don’t always get it right, and sometimes they are spectacularly wrong, they do tend to get it right more often than they get it wrong. They can be very patient and have deep pockets, and the fact that their position (by percentage of shares short sold) remains near the highest level, tells you that they don’t think that Woolworths has left the worst behind it.

Bottom line

There is no doubt that under new Chairman Gordon Cairns, Woolworths has made progress. However, the challenges in the supermarket division - increasing competition, static sales and falling margin - are very, very material. And while the albatrosses of Masters and Big W may have eased, they haven’t gone way, yet.

 

I think you need to see measurable progress in the supermarkets division before you put Woolworths back on the buy list. On current broker estimates, it is trading on a multiple of 20.3 times FY16 earnings, and 16.9 FY17 earnings. Interesting, but not compelling.