Should I hang onto my Woolworths shares?
John Durkan, Coles's managing director, seemed rattled on last week's Wesfarmers conference call. Now we know why. Woolworths produced 3.1% same-store sales growth in the second quarter of 2017 - much better than anyone expected. Coles's comparable number was 1.0%.
Woolworths' quarterly sales growth excited the market - sending the stock up 4% - although it's largely a result of mathematics. Woolworths' base was a weak sales number last time, whereas Coles's was a strong one. The mathematics would always favour Woolworths this period, as we noted on June 21, 2016 (Buy - $21.13). You'd hope that cutting prices by $1bn would spur sales - and it has.
We also said that Woolworths' problems were self-inflicted and therefore fixable. In this result there was more evidence that managing director Brad Banducci has been working on a long list of issues, even if the result itself was disappointing.
Excluding Masters and the fuel business that BP intends to buy, sales rose 3%. But there was damage to margins - earnings before interest and tax (EBIT) fell 15% to $1,301m. Net profit fell 17% to $786m and the interim dividend was down a whopping 23% to 34 cents fully franked.
Concentrating on the food business, it's astounding that the EBIT margin has now almost halved from around 8.0% to just 4.3% in what is the seasonally stronger first half. This is considerably worse than we expected a year ago.
Waste not, want not
Diving deeper, the issues Banducci is fixing can be seen in the gross margin and cost of doing business. Surprisingly the gross margin rose from 27.4% to 27.8%, despite $1bn of price reductions over the past 18 months. This was partly due to significant progress with an important issue - reducing inefficiencies that were leading to stock losses. Less food is now being wasted, and customers are noticing that what's on the shelves is better quality.
You also expect businesses going through a spot of trouble to cut costs. Not Woolworths. The company's cost of doing business rose from 22.2% to 23.5% in the first half. A significant part of the increase here was staff incentives - management explained $110m in bonuses had been paid to staff as business metrics have improved. Motivated staff lead to better outcomes - and here's the proof.
Banducci has been throwing money at the problems in the food business, with the evidence being a collapse in margins. On the conference call he all but admitted some of it was indiscriminate spending designed to do whatever it takes to save Woolworths. Expect management to target spending more carefully in future, which suggests margins have bottomed.
Elsewhere the liquor, hotels and New Zealand businesses performed creditably in the first half. Only Big W was particularly problematic, echoing its counterpart Target over at Wesfarmers. Sales fell 6% and, despite cost reductions, the business only broke even on a trading basis. Writedowns took Big W to a bottom line loss and there might be more to come.
One of the perverse things about investing is that the market looks forward. You'll often see the share price rising while earnings are still declining, just as we're seeing now with Woolworths. The stock is up 8% since the upgrade in Woolworths takes tough decisions from October 29, 2015 (Buy - $24.70) but a whopping 25% since we said our long-term return expectations had increased in Woolworths: Competition cuts in. Remember: if you're not buying on bad news, you're not getting an underpriced stock.
We're not claiming credit here - we certainly didn't foresee the speed of this turnaround. And if anything we're less keen on Woolworths 18 months on. Earnings per share are worse than we originally expected for 2017 and yet the stock surge means the forecast price-earnings ratio is now 23. The turnaround has arguably been fully priced in.
With Coles's John Durkan apparently surprised by Woolworths' price reductions, the risks have risen. He acknowledged that Woolworths' prices were now comparable to Coles but that he wanted to return to price leadership. Tit-for-tat reductions are a risk.
With Woolworths' share price having soared, the doom merchants have gone quiet. It doesn't mean the risks have gone away. But there's no doubt that Woolworths' management has been making excellent progress to fix the business. Masters is history, the food business turnaround is well underway, and only the relatively insignificant Big W remains problematic.
The returns from here are unlikely to be outstanding, but it's undoubtedly a very high-quality business. HOLD.