By Paul Rickard

The most remarkable part of the Woolworths story is how investors, particularly fund managers, want to find a reason to buy it. Maybe it’s because deep down, they like the idea of a former market darling returning to greatness, and this combines neatly with the belief that they are pretty smart at identifying “value”.

Perhaps this explains the jump of 8.25% in the Woolies share price on Monday in response to an update on their operating model. As cooler heads prevailed and shorters regained confidence, it’s no surprise that, over the last two days, Woolies has given a lot of this back. It is now up just 4.3%.

Short-covering rallies can be pretty violent, so when you have a stock that, according to Wednesday’s ASIC figures, has 7.88% or 100.7m shares short sold worth around $2.4bn, an 8.25% jump is not that extraordinary. The question now is whether the shorters will be content to hold their nerve.

My guess is that they will be. That’s not to say that the shorters always get it right. These professionals get some calls spectacularly wrong, but on balance, they get more right than wrong. And they have been right to date with Woolworths. So, was there anything in the statement which will cause them to change their mind?

The “good”

The most encouraging part of the Woolies statement was the comment that the investment in “price, quality, service and customer experience” in supermarkets is leading to “transaction and item growth”. In other words, customers are buying more.

We don’t know how much more, or at what price, as no sales figures were provided.

With price deflation increasing (if you go by what Metcash and Wesfarmers have had to say), this probably still means flat to slightly negative sales for the current quarter. Certainly, you can bet that when the quarterly sales results are announced on 25 August, Coles will have beaten Woolies for the 28th consecutive quarter - yes, seven straight years!

In supermarkets, Coles and Aldi have momentum.

And despite the media focus on home improvement (Masters) and the basket case known as BigW, 80% of Woolworths’ problems have been to do with their supermarket business. Margins crunching and sales falling as Coles and Aldi eat their lunch.

Woolworths is going to slow its new store expansion program from the previously planned opening of 90 new stores over the next three years to now just 45. It is going to exit 17 underperforming supermarkets in Australia, and potentially close another 15. Capital investment will be reallocated to store renewals, following some encouraging signs in the trading performance of six trial renewal sites. It will also adopt ‘sales per square metre’ and ‘return on funds employed’ as key long-term performance metrics.

All good stuff, except with the obvious caveat that very few companies “shrink their way to greatness”.

Woolworths also announced that it will permanently remove 500 positions from its support office and supply chain.

The “bad”

Woolworths provided a trading update, saying that full-year EBIT from continuing operations and before significant items was expected to be in the range of $2,550m to $2,570m. This was marginally less than the market had been expecting, and as the following table shows, is a whopping 36% down on FY15. Further, half on half, it is not getting any better, with the latest half year down by 44% on the corresponding period in FY15!

Woolworths EBIT (before significant item)

The news on BigW gets no better, with Woolworths saying that it expects to lose approximately $30m for its General Merchandise division (BigW and EziBuy), compared to an EBIT of $114m in FY15.

And although further impairments and restructuring costs of $959m are largely non-cash items ($571m), this takes the total in write-downs for FY16 to $4.2bn, and follows $430m the previous year.

The Brokers

While noting the measures new CEO, Brad Banducci, is taking to reinvigorate the Woolworths Group and the three to five year journey they are on, they also sense that the market is being a little optimistic. Overall, they remained concerned about margin compression as the supermarket war continues, and see little opportunity for Woolworths to increase market share.

Following the announcement, Credit Suisse downgraded its rating from outperform to neutral. It retained its target price of $24.50, while Macquarie cut its price to $18.85. According to FNArena, the leading brokers now have a consensus target price for Woolies of $20.10, approximately 14% below the current price of $23.42.

On multiples, the brokers have Woolworths trading on a multiple of 26 times FY16 earnings and 19.7 times FY17 earnings. With dividends cut to around 82c for FY16, this implies a second-half dividend of 38c, and sees the stock yielding around 3.5%.

Bottom line

Woolworths is a potential long-term recovery stock, but in the absence of a significant increase in earnings, it’s hard to see that on any metric that it looks particularly cheap. And it is unlikely that an earnings jump is going to come quickly. Sure, it is cutting costs, but it’s also losing market share and with the grocery wars continuing, deflation is a real issue. When Woolworths is able to point to momentum in sales, then you might be inclined to jump on board. This is going to be a very long recovery story, and at circa $23.50, I don’t think there is any rush to buy.

Not yet.

Follow Paul on Twitter @PaulRickard17