Woolworths (WOW.AX) traditionally was one of the best
performing and most consistent of the companies listed on the ASX.
It was a company that I had always admired and was run
brilliantly by Paul Simons and Roger Corbett. But that was years ago and now,
sad to say, incompetent (board level) management under former Chief Executive Grant
O’Brien combined with significantly increased competition has destroyed the
company’s performance and safe-haven status.
The two charts below shows the problem Woolworths has:
The first chart shows the net profit after tax from
continuing operations (so the whole Masters debacle is not reflected in these
margins).
The second chart shows how the return on equity has
continually fallen from an outstanding 27.3% in 2010-11 to a very mediocre 9.1%
in 2015-16.
What can be seen from the first chart is that
Woolworths until very recently enjoyed consistent margins of around 4% or so.
It is now struggling to reach 1.5%.
To put that in context, you have to understand that
Woolworths total revenue is in the vicinity of $60 billion per year. Therefore,
profit margins of around 4% were translating into net profits after tax of
around $2.1 to $2.4 billion. Now, they are scarcely $1 billion.
Further, if the company was fairly valued at
approximately 16 times net profit after tax at a margin of 4% and now is fairly
valued at about 13 times earnings at a margin of 2%, that means that
theoretically the company is now worth roughly $25 billion less than it was
when its margins were around 4%. And this would suggest that the company is
still very over-valued at current prices.
Now, you can argue with those assumptions and to be
fair, they are very rough approximations, but I don’t think the market has
fully grasped the predicament that Woolworths is in. There is a reluctance to
believe that Woolworths glory days are truly over and there is a hope that the
new management can restore what has been (irrevocably) lost.
The lower margins are due to lower revenue and
significantly increased branch and administration expenses. Coles and Aldi have
taken some of Woolworths revenue and to add insult to injury, Woolworths is
having to spend more to retain the revenue it still has.
The whole modus
operandi of companies such as Aldi and Amazon is: “Your profit margin is
our opportunity.” This means that these companies are willing to operate at very
low margins and this almost always makes life very difficult for incumbent players.
Woolworths enjoyed high profit margins for years, due
to minimal (and often inept) competition. That situation no longer exists and
we are not going back to it.
The situation I’m describing here is not unique to
Australia. I have been watching Berkshire Hathaway sell down huge quantities of
its stock in Walmart in the last few quarters. Why? Because, Walmart like
Woolworths is now the hunted, no longer the hunter.
Personally, I have sold down my own shares in
Woolworths, as I write this I have approximately one third of the shares I use
to hold. I bought these shares in 2003 at an average price of around $11. I
sold half my shareholding at around $34 in January of 2008 and then bought some
of these shares back in 2011. But I no longer have the confidence in the
business to maintain a significant shareholding.
Woolworths can sell off its petrol business, refurbish
stores, tinker with loyalty programs and so on, but it’s very difficult to see
how it can possibly go back to consistent 4% profit margins and returns on equity
of 20% or more and that means the business is worth very much less than what it
was selling for a few years ago.
