Woolworth’s Project Oxygen leaves supermarkets gasping

Adele Ferguson
November 24, 2014
The Age
On November 10, Woolworths and its US partner, Lowe’s, quietly tipped another $90 million into their struggling hardware business Masters Home Improvement.
According to the latest Australian Securities and Investments Commission filings, it brings total investment in the hardware joint venture to a whopping $2.91 billion – a whisker away from $3 billion. How much more it will need to pump in is subject to debate. The company won’t say.
It is a big bucks investment – and a massive risk. An even bigger risk is the long-term impact on the rest of the Woolworths empire.
Besides the amount of money already sunk into the business, accumulated losses are likely to clock up to more than $1 billion before hardware breaks even. The company previously flagged a break-even date of 2016 but in August was forced to retract that. The market now expects it to break even by 2019, which would mean nine years of losses. There is speculation an impairment charge isn’t far away.
If the quarterly figures released late last week by Lowe’s are any guide, the losses from the hardware joint venture are getting worse, not better.
The Masters big box hardware chain and a few other hardware companies took a reputational hit in August after the Australian Competition and Consumer Commission announced a recall of dodgy electrical cable imported from China by a company that has now collapsed. An estimated 40,000 homes and businesses were wired with the faulty cable, which, according to the ACCC on October 31, “may become prematurely brittle and break if disturbed, exposing the internal conductors and potentially causing electrical shock or fires”.
The cost of the cable recall, which involves ripping out the old cable and rewiring it, could be anywhere between $80 million and an extreme case of $600 million, according to Merrill Lynch. The variation depends on how many homes and businesses will need complete rewiring. In some cases a safety switch might suffice.
Against this unfolding saga, some investors are worried the jaws of death have bounced open across the group, at a time when competition has never been fiercer from Coles, Aldi and Costco, and when, by Woolworths’s own admission, it is battling a price perception issue.
They cite Woolworths’s first-quarter sales results, which were disappointing in all divisions. The fear is Woolworths will struggle to achieve 2015 earnings guidance of 4 per cent to 7 per cent net profit growth. Merrill Lynch analyst David Errington gave the sales results a three out of 10.
If Woolworths misses its 2015 earnings guidance, the bells will start tolling long and loud for Grant O’Brien and some of the longer-serving members of the board. In 2011 the supermarket giant missed its first earnings guidance in memory and not long afterwards its then CEO retired.
Crunch time
Put simply, it is crunch time for O’Brien and the board. Hardware, Big W, petrol and New Zealand are all under the pump and the jewel in the crown, the Australian supermarkets division, is starting to look shaky with signs consumers are starting to turn away from the stores on the basis Woolworths isn’t offering the best prices.
Woolworths has long maintained it offers Australia’s lowest-price, full-range supermarket. But if consumers don’t think it does, the company has a problem. Perceptions drive consumer behaviour.
Australian food and liquor volumes fell by 2.5 per cent, the lowest volume growth in more than a decade, according to Morgan Stanley, “as food inflation [driven by fresh food/tobacco excise] ticked up, while like-for-like sales growth retraced.” The concern is if volumes drop, there will be supply chain implications.
The problem for Woolworths is the hardware business appears to be infecting the performance of its overall operations. Woolworths owns 66.7 per cent of the joint venture with Lowe’s, but Lowe’s has an escape hatch: a put option, valued at more than $800 million, to walk away with 13 months’ notice from next October.
Ironically, the hardware business was dubbed Project Oxygen because its aim was to suck the oxygen out of Wesfarmers by going after its best business, Bunnings, which sits in the empire along with Coles, Officeworks, Target and Kmart. The theory was if it hurt Bunnings, it would reduce Wesfarmers’ ability to turn around Coles. Five years on, the strategy has horribly backfired and the perception is Wesfarmers is sucking the oxygen out of Woolworths’ best business, food and liquor.
If it wasn’t for the capital-hungry hardware business, Woolworths could have smashed Coles in 2010 instead of giving it a free kick. If it had sacrificed margins by launching a wide-scale price war, Coles would have been crushed.
Instead it chose to fatten up its margins in the supermarkets, partly to counteract the losses in hardware. In a recent note, Morgan Stanley made the alarming comment: “Over the past couple of weeks, we have met with a number of leaders in the Australian supermarket industry. A common thread in our discussions has been declining Woolworths in-store execution. Rising out of stocks, declining fresh food displays and tired stores were comments of note. We believe recent cost-out initiatives are beginning to affect store performance.”
Comparative targets
Errington wrote a fascinating report in September comparing the remuneration policies of Coles and Woolworths. He found Wesfarmers’s targets were more skewed to growth in return on equity, like-for-like store sales growth and a turnaround of Coles, while Woolworths was more skewed to total group sales, earnings targets and earnings per share growth. “On this basis, we consider Wesfarmers’s remuneration targets to be more aligned to shareholder interests (based on our view that returns on investment are a more aligned objective to shareholder returns than absolute sales and earnings growth and EPS targets).”
It offers an insight into what might be driving some of the decisions, including rolling out new stores, sometimes in existing catchment areas, and rolling out Masters stores, which boosts total sales. It has also been busy selling some stores and leasing them back with long-term leases (presumably to reduce annual lease costs which boosts profitability).
Merrill Lynch notes the duration of Woolworths’s lease commitments is longer than Wesfarmers’s. “The longer the lease duration, the higher the financial risk of the lease in terms of close-out obligations [in the event of the lease being closed out].”
A Woolworths spokeswoman said the company was confident its strategy would “continue to deliver growth and solid shareholder returns, and that we will continue our consistent, reliable financial performance”. In the past three years shareholder return had increased by 56.7 per cent.
Woolworths is trying to change the price perception to win market share. It launched the “Cheap, cheap” campaign, highlighting long-term price drops such as 85¢ bread, reintroduced red-spot weekly specials and is offering other specials.
If consumers see the campaign as little more than a jingle, it will do little to change their attitude. In the meantime the battle for market share between Coles, Woolworths, Aldi, Costco, Bunnings and Masters will ramp up.
If hardware gets in the way of its precious supermarket and liquor business, the board will need to make some tough decisions or investors will make their own.
Either way, Woolworths has got some serious soul-searching to do. As growth slows, competition intensifies and the price perception of Woolworths is thrown into the mix, its reliance on gross margin expansion and cost cuts to keep profits up will become increasingly difficult.
With the ACCC on high alert for any cases where suppliers are being screwed, it paints a picture of challenging times ahead.
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