As the treasurer lauds supply-side economics, a once-controversial recovery theory is gaining traction.This is the essence of modern monetary theory – that government budgeting is nothing like household or business budgeting, for the simple reason that government can create money.
Woolworths fighting back for supermarket supremacy
It’s 10pm on a Tuesday at a Woolworths store on Sydney’s lower North Shore. A lone shopper loiters between a picked-over display of half-price Bonds underwear and a tower of 40 per cent-off Coca-Cola cases. Ten workers stack shelves, outnumbering shoppers by almost two to one. The checkouts are empty, save the self-service line, where a young man buys three end-of-day discounted roast chickens. Out front, rows of shiny new shopping trolleys with green cup holders wait expectantly by the automatic doors. There are still two hours of trade to go.
Behind the scenes, Brad Banducci, the newly appointed chief executive of Woolworths, is pressing ahead with a turnaround plan for the retailer. But scrabbling from a near $1 billion half-year loss in February – its first since listing on the stock exchange 23 years ago – Woolworths is staring down the barrel of what it concedes is a three- to five-year project. The battle in retail could turn bloodier yet.
Banducci – the Woolworths insider named chief executive in February after a six-month global search – has watched the retailer’s shares slump almost 30 per cent in the 12 months he has overseen the supermarket’s food business. The bad news has been unrelenting. Woolworths’ same-store food and liquor sales have fallen for the past three quarters, a trend the retailer doesn’t expect to improve much this year amid stiff competition and price deflation.
Then in January, Woolworths was pushed into an embarrassing defeat, announcing plans to exit Masters, its ill-conceived hardware start-up. Not only did the idea fail to put a dent in Wesfarmers’ Bunnings, it stung Woolworths with more than $600 million in cumulative operating losses over the past four years.
Worse, Woolworths said at its half-year earnings announcement last month that divesting Masters would generate little, if any, cash, excluding payment to its joint venture partner, Lowe’s. That raised eyebrows, considering Masters has more than $3 billion in assets. Liabilities are about $500 million.
“A three- to five-year turnaround is certainly at the longer end of expectations,” said Martin Duncan, a partner at Sydney-based Arnhem Investment Management. “That tells you how bad things are.”
In the 2000s Woolworths rode a wave of more than 5 per cent growth in retail spending and about 4 per cent food price inflation. It also benefited from the fact its biggest rival – Coles – was walking wounded, handicapped by a toxic culture and years of underinvestment. German discount supermarket Aldi, which was opening stores up and down the eastern seaboard, was little more than a sideshow.
Then in late 2007 Wesfarmers bought Coles, turfed out more than 70 per cent of its senior managers, and began ploughing much-needed investment dollars back into the business. It shut many unprofitable stores and concentrated spending on refurbishing Coles’ estate. Between 2011 and 2014, Coles refreshed 339 stores, more than double the number of stores upgraded by Woolworths, whose last big refresh program ended in 2010, according to a Woolworths investor presentation. More than half of Woolworths’ stores are now more than seven years old, Macquarie Research estimates.
With store age such a critical driver of sales, Woolworths has floundered with the step-up in competition. In fact, Coles – long the laggard – overtook Woolworths last year, generating greater sales per square metre in its food business, though Woolworths is still ahead when including liquor, according to J. P. Morgan. Back in 2007 Coles made less than half the food sales per square metre of its larger rival.
The greatest failure, however, was that while Woolworths was able to lean on price hikes to push up profits when the competition was weak, it didn’t change its behaviour once Coles had stepped up its fight. As Coles was drumming “Down, down, prices are down” advertisements into households across the country, Woolworths counterintuitively allowed its prices to creep up, while cutting costs, such as staff on the shop floor.
Those actions juiced food and liquor operating profit margins to 8.5 per cent in the first half of fiscal 2014-2015. Food retailers’ operating profit margins are an average 3 to 4 per cent, internationally.
But fewer staff meant long queues at the checkout and empty shelves, giving customers yet more reasons to shop elsewhere, notably Coles. While Coles’ same-store sales rose 4.9 per cent in the December quarter, Woolworths’ comparable sales slid 0.6 per cent, marking the widest gap between the two retailers since Coles’ change of ownership, J. P. Morgan notes.
Retailers’ high fixed costs – labour, rent – mean that when sales fall, profits fall faster. Woolworths expects its food, liquor and petrol business to make about 5 per cent operating profit margins this year, down from 7.2 per cent in the 2014-2015 fiscal year.
“Woolworths has over-earned for quite a while and pushed profit margins too hard,” said Jason Beddow, managing director of Argo Investments, which owns shares in Woolworths. “Now they’re paying for it. We don’t expect them to get back to historic margins and returns.”
Meanwhile, Aldi, which now has more than 400 stores, has become a real threat.
“Australia is playing out more like the UK than people imagined,” said Chad Slater, joint chief investment officer at Morphic Asset Management, which has a short position in Woolworths. “Tesco didn’t start downgrading earnings expectations until many years after the hard discounters arrived. Once discounters get through 10 to 12 per cent market share and their store density rises, they appear to demonstrate this network effect. That’s the market share levels Aldi is approaching now in Australia.”
And there’s more to come. Aldi opened its first Adelaide stores last month and plans up to 50 supermarkets in South Australia. It will also start trading in Western Australia in the middle of this year, where it intends to open 70 stores.
“If history is any indication, the Aldi effect isn’t a one-year phenomenon,” wrote Morgan Stanley retail analyst Thomas Kierath last month. “It is a slow burn that will continue to take market share from Woolworths, and perhaps even more importantly, lower price expectations in the market.”
By 2020, discounters led by Aldi – the other, Costco, is still small – could have about 15 per cent of the Australian grocery market, Kierath estimates. Indeed, there is a precedent: in the 1990s discounters including Bi-Lo and Franklins had as much as 20 per cent of the Australian grocery market, before they were acquired by the big supermarkets.
Woolworths’ supporters stress it is unlikely to suffer the fate of its British peer Tesco, whose profit margins have been decimated by a discounter-led price war. They say Australia’s growing population should underpin growth in grocery sales. Supermarket sales are barely growing in Britain after 19 consecutive quarters of grocery price deflation, according to consumer analysts Kantar Worldpanel.
Others argue Australia’s unique supermarket duopoly and the fact Aldi has no real discount competitor – in Britain, Aldi and Lidl go head to head – should better protect the mainstream grocers’ profit margins.
“Woolworths has a commanding market position but has suffered from poor management over recent years,” noted the retailer’s largest shareholder, Perpetual Investment Management, in January.
But in some ways Australian retailers look all the more ripe for a pummelling.
One reason is Aldi’s big cost advantage, which helps it sustain rock-bottom pricing. Take labour, the largest operating cost for supermarkets. Aldi’s model – where cashiers also restock shelves at quiet times and customers pack their own bags – and their smaller shops mean it employs just 24 people on a per store basis compared with 115 staff per store at Woolworths. Aldi also opens its doors far fewer hours a day. That’s significant, particularly in Australia, which has one of the highest minimum wages in the OECD. Whereas labour accounts for 10 per cent of Woolworths’ sales, it’s just 6 per cent at Aldi, according to Morgan Stanley.
Woolworths claims change is afoot. It has spent $350 million lowering prices so that by the beginning of January it reckons it was cheaper than Coles on a weighted average of 17,000 items. It is also focusing more on private label products, which it mistakenly neglected in the early 2000s.
But Coles and Aldi aren’t sitting on their hands, raising the possibility Woolworths may need to do more than its strategy to “neutralise Coles” on price and “contain Aldi”. Although Woolworths reports that budget-conscious consumers have returned, the biggest spenders haven’t.
“The only way you get the premium consumer back is to discount dry groceries and become price competitive with Aldi whilst aiming to make your profit margin on fresh food,” added Morphic’s Slater.
The trouble is Woolworths’ balance sheet is already under strain, which hasn’t gone unnoticed by debt investors. The cost to insure against default for $10 million of Woolworths bonds has surged almost 70 per cent to $174,000 a year since the retailer warned last October of the collapse in first-half profits. That isn’t pricing in a default but it shows the shift in confidence.
Fixed charges cover, a key metric for credit rating agencies that measures a company’s ability to pay its fixed costs, has fallen to a more than 10-year low of 2.5 times. To maintain its current BBB+ credit rating, three notches above junk, Woolworths needs to be above 2.7 times.
Meanwhile, Woolworths has said it plans to each year refurbish more than 80 stores while continuing to open 20 to 30 new ones. That looks increasingly challenging. In February, Woolworths cut its interim dividend by 34 per cent and launched a dividend reinvestment plan, a form of capital-raising.
“I couldn’t think of a more exciting time to be inside Woolworths,” Banducci said on his inaugural earnings call as CEO in February. “I think it all lies before us.”
Investors must hope his recovery plan checks out.
This article was first published in the print edition of The Saturday Paper on Mar 26, 2016 as "Chain reaction".
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