Woolworths’ nightmare run isn’t over yet

STEPHEN BARTHOLOMEUSZ
26 FEB, 2016
Business Spectator
The magnitude of the ‘Masters Disaster’ and dramatic loss of competitiveness in Woolworths’ core supermarket business is now apparent. It’s ugly and it isn’t over.
Within the $973 million loss Woolworths reported for the half-year to January 3 today, were a $3.25 billion impairment of its home improvement business’ assets and a 32 per cent decline in earnings within its Australian food and liquor business.
Given that Woolworths and its US partner Lowe’s invested about $3bn in Masters, and racked up losses of about $1bn, the scale of the writedowns — Woolworths’ two-thirds ownership of Masters means that its share of the impairments is $1.9bn — is staggering.
Woolworths still has to negotiate the terms of Lowe’s exit from the ruinous partnership to get full control of the liquidation process, which may mean sending more good money after bad. It also says there may be further restructuring costs of between about $70m and $80m.
With Masters’ losses continuing to blow out even as it opened more stores (its sales base grew 23.4 per cent in the half and its losses 22.9 per cent, to $138m), the decision taken by chairman Gordon Cairns and his board to pull the plug on the calamitous attempt to challenge Bunnings’ dominance of the home improvement business, however costly and belated it might have been, was unavoidable.
While the haemorrhaging from Masters may have been cauterised (at a gut-wrenching cost), the loss of competitiveness in Woolworths’ once completely dominant food and liquor business is almost as disconcerting as the outcome of the ill-fated excursion into home improvement.
Food and liquor sales were down 0.7 per cent in the half-year and comparable store sales 0.8 per cent despite a 4.9 per cent increase in liquor sales — which implies that supermarket sales fell. The gross margin in the Australian food and liquor business fell 55 basis points, the cost of doing business soared 167 basis points and Woolworths’ retail margin — earnings before interest and tax (EBIT) relative to sales — collapsed 222 basis points, from 7.43 per cent to 5.21 per cent.
The continuing downturn in food and liquor earnings, where EBIT slumped 31.7 per cent from $1.9bn to $1.3bn, was despite/because of an investment of more than $350m in lower prices over the past year to improve the business’ competitiveness.
With Coles increasing its EBIT 5.6 per cent in the same half-year and its sales base by 5.4 per cent (4.3 per cent on a comparable stores basis) while increasing its EBIT margin 11 basis points to 4.7 per cent, Woolworths’ biggest competitor is continuing to strip market share from it.
When Cairns became chairman last September he had three priorities. One was coming to a considered view about the future of Masters. That’s been done, albeit at horrific cost. Another was to commit to a strategy for trying to arrest the decline in the supermarket business. That’s been done, although Cairns himself says it will be a three to five-year journey.
With Grant O’Brien acting as a caretaker chief executive and Cairns himself a quasi-executive chairman as the big strategic calls were made, his other key priority was to appoint a new chief executive. After a near-six-month global search, he’s finally done that.
Rather than the international supermarket or food industry executive anticipated, however, Woolworths has elevated the managing director of its food business, Brad Banducci.
Banducci took up his existing role (previously he had been a very successful managing director of Woolworths’ high-performing liquor business) only a year ago, which was seen as a negative for his prospects of being awarded the chief executive position.
Cairns has conceded some difficulty in attracting suitable candidates to the role but, given that Banducci has been executing the strategy for a turnaround of the supermarket business over the past year and that the big strategic decision on the non-core elements of the group’s portfolio have already been taken, the appointment perhaps isn’t a case of giving him a job no-one else wanted.
It does mean that the leadership and strategy of the business will be stable, which is a positive for a business that has been underdoing such a traumatic and destabilising experience over the past year. An external CEO could have caused a hiatus as they came to grips with the business and its challenges and potentially a disruptive change in the strategy that has been in place for the past year.
It should also be said that as both a consultant and executive within the international retail sector, Banducci’s qualifications are solid and his performance on the ground known to the Woolworths board.
The appointment of highly-regarded former Oroton chief executive Sally Macdonald to head the troubled Big W business, whose sales slid another 3.9 per cent and EBIT tumbled 38.7 per cent in the half, ought to enable Banducci to focus on the food, liquor and hotels operations that he is now very familiar with.
The strategy for arresting the decline in supermarkets is to reverse the approach which led to the decline and sacrifice margin to regain price competitiveness and eventually generate sales growth.
While Woolworths says it was cheaper than Coles by the end of the half after investing an additional $150m in price and 100,000 extra hours of staffing and that the second quarter was stronger than the first, it is trying to catch up with a moving target.
Coles isn’t going to fall into the trap that engulfed Woolworths of prioritising margin over sales growth — it continues to invest aggressively in lowering prices. Coles’ sales growth enables it to increasingly fractionalise its costs whereas Woolworths’ flatlining or even sliding sales have undermined the operational leverage of its business model.
While Coles concedes that its liquor business will never challenge Woolworths’ for size and earnings, Cairns and Banducci would be nervously monitoring the improving performance of the smaller competitor as Coles’ John Durkan devotes greater attention to it. Coles might not challenge Woolworths’ dominant Dan Murphy business but it could impact its growth rate.
The complex nature of the attempt to rekindle growth within its core business and change consumer perceptions in the face of strong competition from Coles and Aldi inevitably means there are no quick fixes. It will take years rather than months if it is to be successful.
That means, leaving side the continuing fallout from the Masters exit and the continuing struggle to stabilise Big W, an early improvement within that core is unlikely.
Woolworths itself doesn’t expect any significant improvement in its comparable store sales in its Australian supermarkets in the second half, citing the competition and price deflation in the sector. It expects a full-year EBIT margin of about five per cent in the domestic food and liquor business, which implies further margin erosion and which could lead to the once-unthinkable outcome of Coles having the same or better supermarket margins as Woolworths.
If it were hubris that led to the decisions that let Coles back into the game, ultimately undermined Woolworths’ dominance and framed the calamitous decision to expand into home improvement, it’s been beaten out of the group over the past year.