No easy fix for Woolworths’ old age problem

MIRANDA MAXWELL
1 MAR, 2016
Spectator

The large number of Australians who are invested in Woolworths shares must wince at the uncomfortable memory of Warren Buffett’s rare investing blemish, UK supermarket chain Tesco.
Buffett first bought Tesco shares in 2006 and in 2012 raised his stake to over 5 per cent as shares dropped when the company delivered its first shock profit warning.
He later began to sell down his position when the bad news kept on coming, but it wasn’t until 2014 that he was fully out of Tesco, and by then $US444 million had been lost on the investment.
Australia’s own supermarket celebrity Woolworths has been scrutinised by all and sundry since finally accepting defeat and giving up on its Masters home improvement business, and then posting a loss of almost $1 billion.
Morgan Stanley this week listed 10 reasons not to invest in the stock.
Now analysts over at Macquarie have come up with an eleventh: old age.
Woolworths stores are now nine years old on average, and the retailer needs to spend $1.4bn refurbishing around 400 stores over three years, or about 40 per cent of its network, to address store layout and refrigeration, Macquarie concludes.
Although Woolworths has spent up to $900m in nine months on “price” — charging customers less to compete with the likes of Aldi — its network has already fallen behind Coles and Metcash’s IGA. All that expense could come to nought if the stores aren’t up to scratch.
“The store network is too old,” Macquarie’s report, Searching for the fountain of youth, says.
“The ageing of the network must be urgently addressed in order to generate an appropriate return on investment on recent price investment.”
Actions Woolworths has taken so far are “only the first step in arresting the decline in sales growth and profitability,” Macquarie says, adding that Wesfarmers-owned Coles has surged ahead in sales per square metre.
Store age is a critical driver of sales, with new and recently refurbished supermarkets delivering high single-digit sales growth, while stores which have not been materially refurbished for more than seven years typically delivering flat or even negative comparable growth, research says.
A mature supermarket network needs to refurbish around 10 per cent of its network a year to maintain high quality. This equals 100 stores a year for Woolworths.
Woolworths would need to sell Masters, and possibly BIG W too, cut dividends and raise capital to fund that. But this is essential to stimulate volume, sales and earnings.
“Execution risk remains very high, and earnings risk is to the downside over the next 6—12 months,” Macquarie warns, saying that the decisions taken on the store layout are still more important than the total spend.
Macquarie estimates an uplift of as much as 150 basis points in comparable sales is possible from a major refurbishment program, and Woolworths’ food and liquor earnings could rise as much as 6 per cent, before interest and tax (EBIT).
Every 10 per cent improvement in energy efficiency in the stores that are refurbished would drive a 30 basis point improvement in EBIT margin.
“The time has come for Woolworths to roll out a new format en masse across the network,” Macquarie says, promising that refurbishment is “one of the most accretive methods to stabilise and then restore sales growth to the supermarkets business, the key driver of the share price.”
Other industry analysts suggests Woolworths, and even Coles, might consider emulating Qantas’ venture Jetstar with a lower-cost model with its own separate branding to run in parallel with the flagship supermarkets.
A new sibling brand could emulate the very different business model of Aldi, which keeps costs down with its private label offering and low SKUs (stock keeping units). This would allow it to buy masses of the same restricted-choice products in bulk and go like-for-like against the discounters.
Coles and Woolworths could even make use of their existing stores in rolling out this junior-bargain brand, segmenting their supermarkets and getting up to critical mass quickly. This overcomes the challenge of accessing appropriate sites which has hindered Aldi at times.
Exiting Masters, while hugely costly, does offer new chief executive Brad Banducci the opportunity to reinvest in the core food and liquor business, the critical driver of sales, margins and earnings growth.