The Masters disaster offers some home truths for Woolworths

BUSINESSSPECTATOR
JANUARY 18, 2016
It was the big call, or should that be ‘put’, that Gordon Cairns had to make. With the Masters home improvement business losing huge amounts at an accelerating rate, Woolworths had to, and has, pulled the plug on its disastrous challenge to Wesfarmers’ Bunnings.
Ironically, on the same day that Cairns, the Woolworths chairman, announced the group’s intention to start a process that will end with the liquidation of its home improvement business, Bunnings announced that its proposed $705 million acquisition of the Homebase home improvement business in the UK has been endorsed by Home Retail Group’s board.
Wesfarmers also revealed its plans to invest about $1 billion more in repositioning Homebase as a Bunnings-branded business headed by John Gillam’s right-hand man, Bunnings’ chief operating officer Peter (PJ) Davis.
It’s a brave move that is already drawing comparisons with the ill-fated Woolworths plunge into home improvement here, but Bunnings at least has the advantage of understanding the sector and being able to leverage off an existing global supply chain and has spent considerable time investigating the UK market.
It also has about 50 stores in Australia of similar size to those it is acquiring in the UK, so it understands the offer it can present to UK customers. Homebase, with an existing network of 265 stores, is purely a platform to launch a Bunnings offer in a market where it would be almost impossible, or at least extremely costly and risky, to successfully build a greenfields business.
That irony of Bunnings’ expansion coinciding with Woolworths’ contraction won’t be lost on Wesfarmers’ Richard Goyder and Bunnings’ Gillam.
Woolworths’ ill-fated decision to enter Bunnings’ market was made at a point when, having just acquired Coles, Target, Kmart and Officeworks at the onset of the financial crisis, Wesfarmers appeared vulnerable to an attack on its best business.
Instead, the poorly executed rollout of the Masters’ joint venture between Woolworths (two-thirds) and Lowe’s of the US (one-third) has destabilised Woolworths.
Woolworths and Lowe’s have invested more than $3bn in the strategy and have incurred losses of about $1bn. Woolworths’ share of those losses has been more than $600m and the losses have been increasing over time. The home improvement business cost it $225m last year, with its share of Masters’ losses about $245m.
Cairns faced a number of immediate challenges when he became chairman of Woolworths last year. He needed to remake a depleted board; which he has been doing. He needed to find a replacement for Grant O’Brien as chief executive; the search is still underway. He needed to come to a view on the future of the troubled Big W discount department store group; he’s appointed new management (former Oroton chief executive Sally Macdonald) and appears to be prepared to give it time.
The most critical decision, however, was whether or not to stick with the home improvement business in the knowledge that it would continue to lose $200m-plus for at least the next several years, with no certainty of eventual profitability.
With Woolworths’ core supermarket business experiencing its own issues as Coles and Aldi continue to strip competitiveness, market share and, perhaps belatedly, margin from it, the sharemarket came to the view some time ago that Woolworths couldn’t afford to continue with the losses and the distraction of the home improvement chain. The losses, and the weaknesses of Big W and the supermarkets, were putting a question mark over Woolworths’ investment-grade credit rating.
It would appear Cairns and his board came to the same conclusion. He said today the board’s recent review of the operating performance of the business had indicated it would take ‘many’ years for it to become profitable.
“We have determined we cannot continue to sustain ongoing losses from this business,” he said.
After an “engagement” with its partner, Lowe’s has advised Woolworths that it will exercise a put option it has held over its share of the joint venture, which will then enable Woolworths to exercise its call option over the Lowe’s stake and gain full ownership of Masters and therefore the ability to maximise its value in a sale or liquidation.
The Lowe’s put was valued as an $886m liability in Woolworths accounts last year but the actual cost will involve a negotiation after an independent valuation of the business. There are analysts who believe this could lower the cost to around $500m.
While it might appear odd that Woolworths plans to buy out its partner, at significant cost, to obtain full ownership of such a cash-hungry and value-destroying business, it does appear a sensible strategy.
The smaller part of its home improvement business, the Home Timber and Hardware business, ought to be saleable as a going concern.
While it is highly improbable that anyone would buy Masters, Woolworths will have the flexibility to deal with its properties, leases and stock. Apart from the 60 or so operating stores, Woolworths owns a considerable number of sites that it could either use within its other operations or sell.
The obvious buyer for a handful of key Masters’ stores and sites is, again ironically, Bunnings.
The best guesstimates of analysts have been that Woolworths could raise up to $1bn from selling Home Timber and Hardware and liquidating the rest of the business. While there would be heavy costs associated with quitting leases and, of course, buying out Lowe’s, the net cost to Woolworths might be kept to less than $1 billion — horrific but digestible for a group of Woolworths’ size.
Cairns said it would take at least two months to complete the put and call option process with Lowe’s and then Woolworths would embark on what’s likely to be quite a lengthy process before it has fully exited the home improvement market. In the meantime Masters will continue to trade and continue to lose money.
The Masters disaster has been a humiliating and destabilising experience for Woolworths, which kept seeing false dawns in the business’ performance even as the losses kept swelling.
The decision to cut the losses by abandoning the hardware strategy was, however, an easier one for a new chairman and a renewed board that for their predecessors, particularly as Woolworths’ chief executive — O’Brien — is a caretaker warming the seat for his successor and therefore the board has an even stronger than usual carriage of strategy.
Given the size and direction of the losses and the likelihood that it would be years, if ever, before the business made a profit, the decision Cairns and his fellow directors took was a no brainer, consigning responsibility for the losses to the previous regime rather than carrying it forward themselves.
While it will take a considerable period to complete the exit, it will enable the new chief executive, once one is appointed, to focus on the group’s core supermarkets and liquor businesses, with Big W a minor but manageable distraction.