Don’t wait for the Woolies’ turnaround

Woolworths will recover, but it will take so long there are better investing opportunities elsewhere.

New Woolworths CEO Brad Banducci has a tough job ahead of him. Picture: Brett Costello

Australia’s great pure play supermarket stock — and arch rival to Coles (owned by Wesfarmers) — will turn around, there is no doubt about it. But Woolworths’ recovery will take so long there are better investing opportunities elsewhere.

Rather than hold the stock through the expensive, dilutive turnaround that lies ahead, there are better opportunities in undervalued small and mid-cap names across the ASX.

It’s a conclusion I’ve arrived at after a major examination of Woolworths (WOW) after the recent $959 million of impairment and restructuring charges. My experience with large-cap ASX turnarounds gives me confidence the company will emerge better-managed than during the recent years of strategic failure, but the problem this time is the likely competitive response by Coles and Aldi.

Most likely Woolworths will have to continue cutting prices to win customers back after a widespread perception that the chain is expensive developed in recent years. In other words, there is further margin pressure to come.

There is also the serious threat of even more competition from Lidl, Aldi’s rival discounter in Germany. Although Lidl has been coy about any plans to open in Australia, it is known to be talking with suppliers and has researched sites for a possible distribution centre in Melbourne. Lidl is a ‘‘lights out’’ risk for supermarket investors in Australia because its entry would cause another round of damaging margin compression as stores fight to retain market share. It’s becoming a better time to be a supermarket shopper than investor.

To look at it another way, Woolworths is being turned around but the upside is limited to the outcomes of better management under new chief Brad Banducci. The competitive environ­ment remains hostile.

A recovery is already priced in

The recent higher share price reflects relief management is doing something the market recognises from the turnaround playbook: rebase earnings, slash costs, step back from excessive growth to a focus on profitability. Woolworths will be a smaller, more profitable business. Scheduled net new store openings over the next three years have been cut from 90 to 45 by closing underperforming stores and cancelling some new stores.

Separately, capital expenditure will be reallocated to refurbishment of existing stores. Early trading performance in refurbished stores so far is “very encouraging”, according to management. And 2018 should be a better year for same store sales as the refurbished stores improve.

WOW could be summarised as a slow-growth turnaround with a credit rating problem because keeping the investment-grade credit rating, which is a stated priority, comes at the cost of slower growth.

Constrained credit metrics also don’t leave enough room for capex on existing stores and the former number of planned new stores as well. Asset sales are probable (EziBuy, the petrol business, even Big W?) and underwriting the dividend reinvestment plan was flagged.

Certainly selling off Big W should be considered. More than half a century after it opened in 1964, Big W is yet to settle on how to differentiate itself from Kmart and Target. Basically, it has not been a consistent, adequate performer for over a decade.

The previous headlong rush to open new stores and grow Masters rather than maximise the appeal of existing stores continues to take its toll. Underwriting the DRP would be a stiff headwind for the share price. Why not just omit the dividend for a while? When a dividend is fully underwritten a company issues new shares to the value of the dividend, which dilutes earnings per share and return on equity. Raising enough equity, in this way, to fund the refurbishment of Woolworths’ ageing stores compresses intrinsic valuation to just $23.20.

We’re told this is a three to five year journey, so our valuation is based on an estimate of what profitability could recover to after then. The valuation is around current prices, so the stock is already pricing in a recovery years from completion. The 2017 price-earnings ratio of 19 times also prices in a recovery and is at a significant premium to the market at 16 times. This is not a cheap stock despite the share price downtrend since early 2014.

The thought of not having Woolworths in the portfolio will be confronting to investors used to owning large companies for the comforting reason that they are large. But no investor needs supermarket exposure for the sake of it.

The extended turnaround at insurer QBE comes to mind. This took longer and cost more than expected.

David Walker is senior analyst at StocksInValue.com.au