Merrill Lynch says margin squeeze puts Woolies at risk

Blair Speedy
November 26, 2012
The Australian

RETAIL giant Woolworths has rejected suggestions that it is relying on price cuts from suppliers to prop up earnings, after a report from Merrill Lynch warned that it might be at risk of earnings downgrades if manufacturers were unable to cut prices any further.

Merrill Lynch analyst David Errington warned that Woolworths’ earnings were under threat from increased labour, electricity and rent costs, as well as a slowdown in productivity improvements, which the company was attempting to offset by squeezing suppliers for lower prices.

“The risk to food retailers’ gross margins, in particular Woolworths’, is when suppliers can no longer provide improved trading terms — that is, when the well is dry in terms of being able to provide the retailers with increased rebates,” Mr Errington said.

“Our view is that this time is fast approaching, given the parlous financial condition many suppliers are currently in.”

Mr Errington said Woolworths could be at risk of earnings downgrades as margins came under pressure.

Woolworths reported a gross profit margin of 26.26 per cent for the past financial year, up from 26.03 per cent a year earlier.

Its earnings before interest and tax were up by 3 per cent to $3.352 billion, excluding provisions taken against the Dick Smith Electronics business, which has since been sold.

“EBIT growth is not primarily being driven by a reliance on support from suppliers,” a spokeswoman said.

“Improvements in gross profit have come from a range of different factors and initiatives within the business — this includes effectiveness in promotional activity, improved stock management, reduced shrinkage, benefits of direct global sourcing and successful new store formats — in fact, the largest contributor of these in 2011-12 was shrinkage.”

The spokeswoman said it was also misleading to suggest that Woolworths’ costs were generally increasing.

“Our cost of doing business is well controlled in dollar terms — like other similar retailers, our costs as a percentage of sales was impacted by price deflation.”

Woolworths’ cost of doing business rose from 19.85 per cent of sales to 20.18 per cent, which it attributed to the start-up costs of its Masters hardware business, an increase in new store openings and the addition of new distribution centres.

“We remain confident that recent investments and divestments will enable a new era of growth and productivity,” the spokeswoman said.

Macquarie Equities analyst Greg Dring said the biggest contributor to profit growth for Woolworths and arch-rival Coles was “the transfer of profits from suppliers”, whose gross profit margins had shrunk by 6 percentage points over the past five years.

But in a report to clients he said Woolies’ higher EBIT margin — 7.5 per cent compared with 4.55 per cent at Coles — was not due to higher prices or supplier rebates, but cost control, “a competency it is highly regarded for”.

Anton Tagliaferro, investment director at major Woolworths shareholder Investors Mutual, said while Woolworths was no longer producing the “fairly spectacular” growth seen over the 10 years to 2007-08 when profit growth peaked at 25.7 per cent, earnings were still increasing and it was investing for growth.

“There’s no doubt that Woolworths’ growth has slowed in the last few years, one reason being the resurgence of Coles, which has been revitalised by new management,” he said.

“Before that, Woolworths had very little opposition to their dominant position.

“But I hardly think it’s doomsday for Woolworths. Clearly the earnings growth that Woolworths enjoyed for many years won’t be repeated in a hurry because Coles are obviously here to stay and they’re much more competitive, but their earnings are still growing and they’re still rolling out supermarkets.”

Woolworths forecasts net profit growth of 3-6 per cent this financial year, and plans to open 35 new supermarkets.

UBS analyst Ben Gilbert has said the opening of new supermarkets is running ahead of market demand, “diluting returns for those more mature retailers such as Woolworths”.