Woolworths: My name is Brad and we're an alcoholic
Last Friday, new Woolworths CEO Brad Banducci was not holding back on the things that are wrong in the business in his half yearly result. Here are our thoughts on the result and the conference call.
Back again with another blog?
We try to blog every second week or so – after all, our main job is running clients money to generate a return for them. However, with the Woolworths result out on Friday and given it seems my thoughts on Woolies have developed a life of their own, it seemed appropriate to put one up.
But just in case there is anyone from the Woolworths legal department reading this – the above is not a reference to your new CEO’s drinking or non-drinking predilections(I have no idea if he enjoys a beer or two or not). Rather it is a reference to - I am told - newly joined members of Alcoholics Anonymous (AA) one is required to stand up and say at their first meeting. Apparently, step one of the treatment process involves admitting in front of people that you have a problem. Woolworths, as the alcoholic, in essence did this Friday.
So was Friday good or bad?
In a sense Friday was good: the conference call was a litany of the things they are doing wrong with Brad Banducci, the new CEO, not holding back on the things that are wrong in the business (we’ll get to the CEO selection process later). IT implementation problems; not enough staff on weekends; inability to get premium big basket shoppers back; too much control from head office; and everyone going on boot camp. It was like an alcoholic listing their problems (including some that we weren’t even aware of!)
So is this the bottom? Admit the error of your ways and find comfort in the forgiveness of the market? Credit Suisse certainty thought so, upgrading the stock to “outperform”, with comments like this on the conference call:
Grant Saligari: “The talk earlier around culture and strategy is music to my ears, I mean, you've almost got me over the line.”
Like an AA meeting, I’m more of the opinion that the journey begins here, not ends here.
I don’t think it’s the new CEO/Chairman, who guided the market to a 3-5 year timeline, who is delusional, rather it is the newly converted bulls like David Errington at Bank of America Merrill Lynch, who was disappointed to hear this, wanting it to happen a lot quicker:
Gordon Cairns: “…And finally, what I'd say to you is that the reason why I've said – this is a three to five year turnaround is exactly the point we make, we don't change culture on a dime.”
David Errington: “I'd like it done a bit sooner than three to five years, though, Gordon. I mean I understand that, but three to five years is a little bit into the` never-never’.”
Gordon Cairns: “Yeah. Well, we've got a simple answer to that which is, if you look at the proxies for turnarounds, there's a good proxy at Coles, as to how long it took them. There's a good proxy currently at Tesco, as to how long it's taking them. I'm not suggesting you wait three to five years for any progress, I'm suggesting you wait three to five years until you see the result of the progress.” (Emphasis added)
Even if one allows for this turnaround to have begun 6 months ago, which is dubious, we are a minimum of 2.5 years away from being complete at the short end of the timeline and 4.5 years at the long end of management guidance. I’m inclined to agree with them – they know more about the internal issues than we do.
Now markets are forward looking, I’ll concede that. But my experience is that it is impossible to be that forward looking.
And unfortunately, unlike AA, there are people (Coles and Aldi) who are not there to assist in helping the long recovery process, rather it is their job to not allow it to happen easily. Leave lots of alcohol lying around, so to speak.
Coles in particular will be aware of this – after all, their rehabilitation was largely allowed to happen easily because Woolworths was more focused on driving up margins. I doubt their management will make the same mistake again.
But before we go into the consequences and the path forward, here is a quick recap of the result.
No doubt most readers would have read a broker note or two on the details of the result, so there is no point me going through the details of all the divisions. Let’s focus on what were perhaps the key points/little touched upon:
1. It was another downgrade: Perhaps not mentioned enough in the weekend press, because Woolworths have moved away from giving formal guidance of a set EPS number, this seems to have slipped through. Their prior guidance was “-28-35% in the 1H”.
By coming in at the lower end of guidance and then giving guidance of 5% EBIT margins for the year, after running at over 5% in 1H16, with consensus numbers where they were the consequence is that consensus numbers will have to come down by 4-6% for FY16 as the 2H EBIT margins will be 4.7%.
2. Costs are going up: The prior focus has been a lack of price competitiveness for the business and most of the reduction before was arguably price related. What was new on this call was the admission by management that they have under-invested in variable costs (labour mainly) in stores. This is what is causing stock-outs (where you find an empty shelf) and queues.
3. Like for Likes not as bad as feared, but there are other problems: After the Wesfarmers result (4.3% LfL sales growth), there was a lot of concern that WOW could be really bad. However, it wasn’t as bad as feared, with the December improvement being grabbed onto by the bulls….which conveniently forgets management saying January and February weren’t great. See below for the Morgan Stanley backed out monthly sales.
It’s hard to call December a new trend – looks more like an exception rather than a new norm. The issue was the composition of the revenue: prices were down more than expected, volume was up, leading to lower margins.
4. More EDLP: This is a bit long-winded, but if you don’t want to read it all, please skip to point 5, the summary being more price cuts for no extra revenue.
EDLP stands for Every Day Low Pricing. It’s the $2 milk you see in the shop. It’s the opposite of “Hi-Lo” pricing, which are the promotional discounts designed to attract you and then get you to buy something at a higher price than you weren’t thinking about.
It originated from Walmart in the USA where it was very successful in their business. Suppliers like it as it gives them certainty on volume and customers like it for the price. It was tried here under Roger Corbett and was largely dropped, but Coles bought it back.
Why didn’t it work? Because if you already have the largest market share, people don’t buy 50% more milk if its always cheaper (on the other hand if Virgin runs their base fares 50% lower, you may do more flying holidays and choose them even on the routes where they are a bit more expensive as you are in their frequent flyer programme). It’s called the price elasticity of demand and for airfares it is very high and for food it’s very low.
So since only a small number of shoppers can be induced to change to your store, given you have a high market share already, you are basically giving discounts to people who already shop with you which is greater than the number of new shoppers you attract.
Coles has used it to attract market share from Woolworths. All stores will use a combination of strategies, but Woolworths made the point several times on the call that they are planning on increasing their EDLP offering.
In short – more price discounting for no uplift.
5. Masters won’t see much cash: Bigger than expected charges and looks like they won’t be getting much cash at all out of it. Small stuff in the larger scheme of things, just not a positive.
6. They are running close on their Fixed Charge Cover ratios: Now this was interesting. Phil Kimber pointed this out on the call:
Phillip Kimber: “And my second question was on the balance sheet, I think you provided in one of the financial metrics pages that your fixed charges cover was 2.5 times. And I think Standard & Poor's talked to 2.7 times to maintain the current rating you've also made that change to your DRP.”
David Marr: “…Why don't I have a go at that. We've had a lot of conservation on our balance sheet and overall capital management with the Board as you would expect. And the outcome today is one of the slides is the culmination of that. So we're very clearly committed to a solid investment grade rating. We're working very openly with the rating agencies. So we're clearly aware of being slightly below on a pure metric sense, the current rating requirement BBB+ and Baa1, but that is something we're working through with them.” (Emphasis added)
I talked in our blog last year about it and this seems to be an issue, albeit a small one for now. Ratings agencies will probably roll over for them, but it confirms what I thought: they are running really tight in this area. Watch this space later this year.
7. Dividend Cut: Well we told readers they would need to do it and they did. Can’t say you weren’t warned. A dividend reinvestment plan discount is a stealth capital raising on top.
8. New CEO: I’m sure Brad is a very competent manager, but it says a lot that they spent 7 months with a pretty much uncapped budget looking around the globe and the best that could be found was sitting next to you, having never run a food business before. Really? Sounds suspiciously like you couldn’t get anyone really good who wanted to sign up to fix the mess at the price you were offering….that said the CEO isn’t what makes or breaks this (sorry to say, CEOs have less influence than people think). Anyone half competent can see what needs to be done.
No, it mainly changes the way we receive information going forward: an external appointment would “kitchen sink” the next result and get all new heads of divisions in and get the charges out of the way and disassociate themselves.
Brad on the other hand will always be associated in some way with the history, so we’d expect to see a “dribble” of bad news going forward as “kitchen sinking” is the equivalent of a mea culpa for all those who remain in the firm.
Which brings us to the key question - is this the bottom?
Since we started writing on this, analysts and the buy side in particular have consistently overestimated earnings. One chart we put in at the start has stood the test of time – we have included it again below - EBIT margins at 4.7% in the 2H16 are on track to the numbers we suggested back then (which seemed ludicrously far away when they were at 8%).
The price action on Friday was consistent with shorts covering who had gotten really short ahead of the result betting a really bad one that didn’t eventuate, and long buyers betting that this was as bad as it gets. A local fund manager said as much: (“If this is as bad as it gets, 5 per cent margins is not such a bad results.”)
Now, one of the key risks in any investment is hanging around too long on a stale idea, so I am happy to explore the idea that this is the bottom, the problem is it just doesn’t gel with what management says nor experience. Consider this quote from the conference call. Craig Woolford is an analyst at Citi:
Craig Woolford: “I'd like to pick up where you just left off there, on the 5% margin. How do you determine, and why did you put in print, that you expect a 5% EBIT margin?”
David Marr: “Right. I'll have a final go at that, Craig. If you just go back to this time last year, we said we would no longer give guidance and we'd be informed by the consensus view in the market. From where we're sitting now, our view as to our performance was below the market, and therefore we needed to provide the clarity on that. And we could have done that in a number of ways, but we wanted to do that, we thought, in the most helpful way, in the most transparent way for the market, to give you a sense as to where we're heading.
If we were in line with market expectation at the time then we wouldn't have needed to do anything, but that wasn't the case.” (Emphasis added)
Ok, so management is telling you that market expectations for the earnings of the business is above what they are seeing from inside the company – and this is despite them downgrading massively just a few months ago. I’m not sure how much more direct they can be!
But maybe this half is as bad as it gets? That would imply the business returns to growth in 2017, yet we know costs are going up from here. There is also the issue of price and EDLP. Again, lets return to the people who know more about their current business outlook than we do:
Gordon Cairns: … “I'm suggesting you wait three to five years until you see the result of the progress.”
That doesn’t sound like someone who thinks his margins are rock bottom and about to bounce!
Markets do of course correctly anticipate the bottom, it’s just they incorrectly do it more often. Tesco is still meandering along, and WOW forecasts show no sign of bottoming just yet.
Stay short – the $18 price target remains our base case, and is becoming increasingly likely to be hit soon: with earnings now at $1.39, a 15 x multiple now (where stock is likely to trade) is $21 now. We see $1.10 to $1.2 in 2017.