FROM BEHIND THE PAYWALL
Why Woolworths is getting whipped
First published in September 2017.
Woolworths’ troubles stem from a combination of external factors and its own missteps. But those willing to sit it out can expect the business to be in a much stronger position in the next three years, according to group CEO Ian Moir.
This is not a happy story. It is a story of trepidation, disappointment and unmet promises. Growth has slowed at Woolworths, until now the perennial darling of the retail sector. At the heart of its problems lies Australian department chain David Jones (DJs), which Woolworths bought in April 2014 for R23.3bn — the largest-yet deal involving an SA retailer, which some analysts warned was a steep price to pay.
Group CEO Moir (58), a Scot who was CEO of Country Road in Australia for a decade before taking the reins at Woolworths in 2010, knew it wouldn’t be easy. But he probably never expected it to be this hard to turn Australia’s largest department store chain around.
In an interview with the Financial Mail, Moir admitted as much. "It is harder. It has taken us longer. We are investing a lot of money. But we didn’t see an economic downturn in both the markets we’re operating in when we bought [DJs] and set our targets. The disgruntled shareholders have sold. The others share the vision, see the value and are holding the faith."
Only, there are a lot more disgruntled shareholders now than there were five years ago, when it seemed a new Woolies food store was opening on every block and the company could do no wrong. For years, it was a "buy", but now most analysts rate it a "hold".
This year, its stock has tumbled 16.5% — worse than any other retailer, including clothing rivals Foschini Group (TFG, down 12.7%) or Truworths (up nearly 1%), or food competitors Spar (down 16%), Pick n Pay (down 2.4%) and Shoprite (up 23%).
Woolworths has cut margin guidance on its SA clothing business and on DJs, amid tough trading conditions in SA and Australia where politics are uncertain, spending and wages have stalled, and excessive promotional activity reigns.
The message is clear: gird your loins — at least until 2019.
It’s not like the market wasn’t warned. This was Moir in 2015: "In the first instance, we will bleed." And in 2016: "We don’t expect to make any money for the first couple of years [from its Australian food play]". And in February this year: "We got stuff wrong, and we got it wrong badly in Private Label."
But for investors who may have assumed Moir was just being overly cautious, it’s cold comfort.
Hard numbers are what most people focus on, says Michael Treherne, portfolio manager at Vestact Asset Management. "Patience and the market don’t go together. For the short term [it looks like] they probably overpaid a bit for the asset, compounded by the R421m cost of the rights issue and the dilution effect of the extra shares."
But, Treherne adds: "I think in the long run, the purchase of DJs will work out well."
It won’t be easy. In a research note two weeks ago, JPMorgan warned of the "higher than average execution risk for this business", citing the numerous things Moir will have to get right for it all to work out.
Of Woolworths’ problems, some are self-inflicted and others are external. The company put in place optimistic targets of R1.4bn it expected to make from the deal, claiming it would place up to 20% of its "private label" products in DJs stores.
So far it has been a bust. It has been the worst time to try to execute the largest-yet deal in SA retail history. As Vestact put it, "people don’t splash out on new wardrobes when bank balances are low and when they don’t feel good about their job".
The underlying fundamentals, however, are weak, and consumers just are not spending as much on clothing as they used to. And when they do spend, they are picking perceived value retailers like H&M and Cotton On.
The SA clothing arm of Woolworths generates a third of the group’s profits — more important to the bottom line than food, which accounts for more revenue but only 24% of the profits.
Under Christo Claassen, Woolworths’ SA clothing division had taken some positive steps: it had built credibility in the fashion market and shortened the lead time between ordering the clothes and having them in the store. Today, about 70% of its womenswear business has a lead time of 6-8 weeks.
But grim consumer sentiment meant that nonetheless, for its year to June, Woolies’ SA clothing division’s volumes fell 7.5%. This was better than Truworths (down 10%) or Mr Price (down 10.6%), but still nasty.
What it means: Road to recovery won't be easy as the world of retailing changes, which is why most analysts rate it a "hold"
Damon Buss, an equity analyst at Electus Fund Managers, says Woolies’ clothing and general merchandise business is "mediocre".
"They are selling 25% fewer same-store units than they did 10 years ago. They also lowered their medium-term margin guidance from 18% to 16%-17%, which is necessary if they are going to hold their market share in SA, which is currently around 12%."
Operating profit was down 6% and sales grew just 1.4% in the Woolworths clothing and general merchandise division. On the plus side, gross margins were well managed, down only 40 basis points to 47.9%, helped by efficient local sourcing and promotional activity.
But the clothing business should be helped by its DJs partnership. Thanks to this tie-up, its share of the beauty business, currently a paltry 3%, is set to grow as it has signed brands including Chanel, Estée Lauder, Jo Malone and La Mer, which will be put into 34 stores by the end of the year.
Says Moir: "We’ve put this into 14 stores so far. Customer feedback has been incredible. Zyda [Rylands, SA CEO] and I were at Canal Walk [Woolworths] and a customer said, this is fantastic, I can come here now and I no longer need to go to Edgars."
It’s some vindication for Moir’s "complete shop" strategy, which many thought was bonkers.
But it is Moir’s expansion of the food business that has been his biggest winner.
The plan to extend "stock-keeping units", a revolving group of 7,500 food products on sale at specific times, is thriving.
The result: operating profit at Woolies’ food business grew by a solid 8.3% and revenue by 8.6%.
It’s a savvy move, since food retailing is in many ways the last bastion of spending in tough times. The landscape is highly competitive, with old foes like Pick n Pay on a recovery path and new ones like Shoprite’s Checkers muscling in (see page 24).
Victor Mupunga, a research analyst at Old Mutual Wealth Private Client Securities, says the Woolworths Food customer is resilient — which is why the company was able to push price increases of about 8%.
"Woolworths has been adding new space quite aggressively," he says. "Most peers were not able to do that, which, coupled with Woolworths’ higher margins relative to peers, is an indication of the health of the SA food business."
Mupunga warns that growth in the second half of the year was weaker than in the first, which suggests "trading could still get worse".
This is especially concerning as Shoprite targets the same high-net-worth customers who traditionally buy food at Woolies. "We haven’t seen any signs of notable market share losses to Checkers, but it is worth keeping an eye on," says Mupunga.
Electus’ Buss believes the food business is the "jewel in the crown". He says Woolies’ product quality and innovation allow it to charge a premium, which means it earns higher margins on food than its rivals.
But, he cautions, even wealthier shoppers aren’t immune to the wider economy. He cites the significant fall in consumer confidence caused by the cabinet reshuffle, credit rating downgrade, Gupta e-mail leaks and the like for having an impact on richer consumers’ willingness to spend.
Throw in the tax increases for those earning above R1.5m/year and you see why shoppers are cutting back on "indulgent purchases".
While the Woolies share price is the weakest it has been in five years, should long-term investors now buy the stock at a discount or should they wait?
Patrice Rassou, head of Equities at Sanlam Investment Management, believes it’s a good buying opportunity. "The stock has derated to levels last seen 6-7 years ago," he says.
But Matthew Zunckel, equity analyst at Mvunonala Holdings, believes there are no short-term catalysts that could help the stock recover soon. And he says there’s a risk it may have to impair the DJs investment further, which would put more pressure on the price. "While the dividend yield at 5.2% does look interesting, there are better dividend plays in the retail sector that would also be more geared to a recovery in the SA consumer," he says.
Woolies’ p:e of 14 isn’t exactly a bargain. Even on a forward p:e, looking ahead a year, this ratio is still around 13.
But if it can fix Australia, profits will change this and the sentiment will shift.
Sceptics have been quick to class the DJs deal among the assemblage of ordeals faced (and failed) by other SA retailers in Australia.
With the exception of Country Road (which has had a modest sales recovery thanks to fresh blood in Scott Fyfe and Darren Todd), DJs has been a big fat let-down.
When he did the deal, Moir’s reasons were compelling: it would give Woolies scale in the southern hemisphere and diversify its earnings.
During the full-year period, DJ’s sales inched up 1% to A$2.2bn, while operating profit plunged 25% to A$127m.
Store sales were down 0.7% on a poor private-label performance, retail space decreased 0.8% and electronics business Dick Smith exited from its stores.
This will be only slightly better than its closest Australian department store rival, Myer. Brokerage UBS cut its earnings targets for Myer over the next three years by as much as 23%, expecting it to report a net profit of A$69m.
Of course, this shouldn’t sugarcoat the fact that Australian consumers are also in trouble. Changes to mortgage regulations mean Australian consumers remain deeply in debt. And, as in SA, competition from foreign entrants has intensified too.
In recent months, online retailer Amazon said it plans to move into Australia, a prospect which has many retailers quaking.
Zunckel says the negativity around Woolworths is justified as the "synergies" it wanted from DJs will take longer to emerge and will probably be lower than expected.
"This is reflected in the lower margin guidance [10% to 7%-9%] they presented to the market for DJs in their recent results. Most of the synergies were supposed to come from the rollout of [their] private label [products].
Private label share of DJs has improved materially since the acquisition. However, we haven’t seen the margin improvement this was supposed to bring."
When the deal was announced in 2014, one of Woolworths’ main thrusts was to sell its own brands — Studio W, JT One and RE: — to capture more of the gross margin and grow private-label contribution at DJs. Woolworths had created the concept of "premium private label" in SA, so it appeared to be a "no sweat" move.
At the time, DJs’ private label accounted for just 3% of sales; the plan was (and still is) to increase that to 20% by 2020.
It has not worked out as planned.
Apart from wonky pricing, there were stock issues due to Woolworths’ systems not being able to talk to DJs’ outdated systems. And the amount of space dedicated to merchandise pads was disproportionate in certain stores. In short, Woolies brands just didn’t resonate with Australian shoppers.
Buss says the market looked at the pedigree of Woolworths’ management and overestimated their ability to complete these projects easily.
To his credit, Moir admits to the mess-ups and says they’re being fixed.
"We’re going to do it through Country Road Group [as opposed to the Woolworths brands] ... we can fix this, we can get it right and we can get back to what we said we were going to deliver," he adds.
There has also been fret around the amount of change that Woolworths is pushing through the business.
For a start, the DJs head office is moving from the Sydney CBD to inner-city Richmond in Melbourne, where it will share space with stablemate Country Road in a new campus-style HQ.
There are good reasons for this: real estate costs in Melbourne are lower and the city is the retail and fashion capital of Australia. Woolworths will also score incentives to offset the cost of the move, including recouping A$15m from the Victorian state government. And the change of address is a neat way of getting rid of dead wood.
The other parts of the DJs turnaround include rolling out premium foods (see page 48). It will do this with the help of Richard Cooper’s In2Food, its biggest supplier in SA, which has already set up two factory kitchens in Sydney.
There is also a multimillion-dollar revamp of its flagship Elizabeth Street store, led by Benoy, an international architecture and design firm, to be completed by 2019.
Dave Thomas, Woolworths Australasia COO, says the reason for the long renovation time is that it has to be done in phases to minimise the impact on DJs’ daily trade at its Elizabeth Street and adjacent Market Street stores. Says Moir: "We’d like to do less but we can’t. It’s all interlinked and dependent on each other."
Though the market is justifiably worried about the execution risk of fixing DJs, a lot of the heavy lifting has already been done. For example, it has sold the Market Street store for A$360m.
And in the rest of its business, it has introduced new merchandising and finance systems, which gives it a single view of customers across all businesses, as in SA.
Mupunga says Moir’s management underestimated the task of turning DJs around. "Turnarounds, especially those of size, often take longer and require more capital than initially indicated. We are seeing that with DJs at the moment in that the time horizon is being pushed further out." But he adds that at least Woolies’ management has been clear and consistent in how they expect to fix it. "What remains uncertain is the timing and size of synergies," he says.
It’s all complicated by the fact that the stately era of department chains has ended.
There is a chasm in retail, created by globalisation of retail competition, online shopping and the ambivalence of how and where people will do their spending.
When Woolworths bought DJs it was not simply an exercise in nostalgia to revive a dead retail format. Moir had faith in the strategy, believing department stores remained relevant amid seismic upheaval in the retail industry.
There has been a purposeful shift towards a new narrative for department stores: the parting of ways with Dick Smith and DJs’ exit from audiovisual retailing, the curated version of smaller DJs outlets in Sydney’s Barangaroo area, as well as its new food
service plans backed by chef Neil Perry, attest to this.
Says Moir: "In the world of the future, retail will have to be engaging and entertaining, there has to be a destination, and there has to be an experience. And a combination of food and clothing can give you that. It separates us from the pack."
Woolworths had to alter its vision.
"Not to change your business model, not to adjust to structural change facing retailers globally, not to invest in systems and process and the skills that the change requires, is a mistake," says Moir. "It might be hurting us now but we’ll be in a much stronger position over the next three years."
To give effect to this, Woolworths will spend between R4bn and R5bn this financial year. Which means cash generation has slowed and returns will fall.
But in a few years, if Moir is right, it’ll be a much stronger business. He’ll be conscious that having missed its targets so badly on the DJs deal, the stakes for him to be on target on this score are higher than ever.
Rebound stories are not for every investor. But those willing to steel themselves for the long haul would do well to channel advice from 1990s rockers Guns ’n Roses: "Just a little patience is all you need."