Since Woolworths reported its 2008 interim results late last month, the company’s shares have fallen around 10%.
That’s partly to do with the nature of the rally of the past nine days, which has been concentrated among miners, resource stocks, banks, builders, building products and other companies considered by investors to be early beneficiaries of any recovery.
Not that there’s a recovery, just those green shoot’s and few nice words from a number of bank executives about trading conditions.
Retail sales are a bit firmer, it seems in the US and here, even if the Reserve Bank remarked that retail conditions were weaker in February.
For that reason so-called defensive stocks like some retailers are no longer as attractive and that includes Woolies, which outperformed the overall market in 2008 quite handsomely.
But there are also signs of worries about the retailer’s current strategy; there are suggestions that it has run out of puff and could be wasting time and money searching for new growth.
Leading the criticism has been Merrill Lynch and its retailing analysts.
At the time of the interim profit statement three weeks ago, ML said:
"There were elements of softness…that took some of the “icing off the cake”.
"These elements included NZ Supermarkets and Consumer Electronics (CE). There was also less profits on property sales, which is probably a positive.
"Operating cash flow also concerned us, falling from the unsustainable $1,952m in 1H08 to $1,327m in 1H09.
"Our concern is WOW capex is too aggressive, and that it may not generate an acceptable return. We are particularly concerned toward the level of spend in NZ and in CE.
"We have learnt not to question Woolworths’ strategies in the past…they have seldom been wrong. However, we have concerns with throwing a lot of money into NZ and CE…particularly in current economic conditions and given the current industry position Woolworths has in both businesses."
This week the firm returned to Woolies and issued a much more strongly worded report.
The strength of the report can be seen from the change in recommendation from a ”Buy” to "Neutral".
Here’s what the firm said:
Woolworths current investment strategies concern us.
We have had a BUY on Woolworths because of its capability to generate cash flow and increase its return on investment.
We saw the next 2-3 years as being extremely lucrative for shareholders – with large dividends and capital returns.
However, the current strategic direction being undertaken by the company is putting our investment thesis (increasing shareholder returns) at risk.
What concerns us is the level of capital Woolworths is currently spending. Given the current state of Woolworths’ businesses and the current economic outlook, we believe that WOW could reduce its capex over the coming 2 to 3 years, maintain its earnings growth, and undertake capital management to increase s/h returns.
We are concerned that Woolworths is currently too focused on improving its underlying business from a customer standpoint and strategically disadvantaging its competitor – and not enough from its own shareholder standpoint.
Woolworths is well placed to achieve strong earnings growth over the next few years – although we now believe that it will be spending excess capex to achieve it.
We believe continued reinvestment in its store network and price will further drive sales growth and widen the performance gap relative to its competitors – but at too great a cost to returns on investment.
Woolworths is in a commanding position, and is an outstanding retailer.
However, returns look like they a re being neglected.
What concerns us is the level of capital Woolworths is spending to achieve such growth ($2bn pa for a number of years)…and the underlying reasons it appears to be spending the capital for.
We are somewhat concerned that Woolworths is spending the capital more for its customers and to keep a competitor in an uncompetitive position – rather than to maximise returns on investment for shareholders.
Over the coming 2 to 3 years, we see Woolworths’ returns on investment being relatively flat – whereas we believe that the stock fully values the company delivering increasing returns.
We would consider returning to a more positive recommendation if the company were to cut its capex, work its capital harder, and generate increasing returns on investment.
However, when looking beyond the earnings growth, a cause for concern to us is that Return on Equity for Woolworths has fallen from 40.8% in FY05 to 26.1% in FY08.
And going forward, despite forecasting Woolworths’ NPAT to grow by 10.3% in FY09, 11.3% in FY10 and by 11.3% in FY11, we expect Woolworths’ ROE to fall to 25.6% by FY11.
We maintain our view that Woolworths is a great company managed by excellent retailers.
However, under the current strategic direction, we expect returns to investors to remain relatively flat for a number of years. And given the valuation of the stock, we see out performance unlikely given a flat returns profile.
In FY08, Woolworths’ ROE was 26.1%, and we forecast ROE to fall to 25.6% in FY11. WOW’s ROE in FY05 was 40.8%. ROE has limitations – but this highlights the issue we currently have with Woolworths…the company is not focused on improving its returns to shareholders at this point in time.
We expect high priced stocks whose returns fall or languish (even off very high bases) to languish. Woolworths is now in this ca
