Here is an old idea that I think still has some potential.
An elevator pitch: Woolworths is facing pressure from low-cost competitors, primarily Aldi and CostCo. Australian supermarkets including have had some of the highest operating margins in the world at 5-7%, even higher than the UK before Aldi entered the market. Aldi has a 20-year plan to take market share in Australia, growing its store base around 10% per year. That market share will be taken from incumbents, including Woolworths leading operating margins to fall at least to 3-4%.
There are a few trends that shape the Australian supermarket industry:
- “Value for money and good promotions” have become a more important driver of shopping behaviour while “Quality/range of fresh foods” has become less important
- Consumer awareness of Aldi and CostCo keeps on rising
- Private label groceries are taking market share from established brands. Woolworths has the lowest share of private label groceries while Aldi has 90-95% private label.
- Customers are buying smaller baskets and shopping more often. The average store size for Woolworths is 3000sqm vs 700sqm for Aldi.
Given the above trends, Aldi and CostCo appear to be a sweet spot in the years ahead:
|Unique selling points|
|· Bigger selection
· Brand names
· Nicer store setting
· Don’t have to pay for trolleys
· Don’t have to pack your own bags
· Better online service
|· 15% cheaper according to CHOICE
· Similar quality
· Fast shopping experience as stores are small and check-out around 40% faster
The reason why Aldi can price its goods much cheaper than its domestic competitors comes from:
- A lower of employees: 47 staff per store compared with 116 at Coles and 124 at Woolworths
- A lower number of SKUs creates bargaining and hence purchasing power
- A lower number of SKUs and efficient check-out systems means Aldi tills can process 42 items/minute vs 15/minute in supermarkets, partly because cashiers are able to memorize PLU codes
- Effective marketing: Aldi’s no-frills marketing campaign was voted the best in the UK in 2014 and received the comment “most memorable brand”
- No backroom inventory: products are displayed in the shipping box, which saves time unpacking goods
- Patient capital: Aldi has a 20 year plan, perhaps possible only because it’s privately owned
- Store layout is same for all stores and not remodelled very often
- What differentiates Aldi from Woolworths’ private label brand is that they are not generics. Aldi’s groceries are of much higher quality, and most often supplied by major brands such as Nestle and Kellogg’s, only under their own brand name.
- Solid execution: Aldi received Canstar Blue’s most satisfied customers award for the third time in three years
This provides an ability to undercut Woolworths and Coles. Aldi’s prices are lower in pretty much every category, and 15% lower overall. Yet their margins are similar. Margins at Aldi at 5.2% in 2013 were higher than Cole’s 4.3% but lower than Woolworth’s 7.1%.
Here is a direct comparison of a similar quality goods between different grocers. Aldi clearly wins:
Aldi’s sales/sqm is far higher than either Wesfarmers or Woolworths. Aldi’s sales/sqm mirrors that of UK and Germany. A low sales/sqm at Kwik-Mart in the UK preceded its demise.
|Sales per square metre A$||2011||2015||Growth|
Days payable outstanding in the industry are around 50 days for both Woolworths and Wesfarmers, and have been at this level for a few years. This is higher than global averages but the level is stable thus far.
There are clear signs that inventory is not moving. Days sales of inventory has been creeping upwards the last couple of years, which clearly indicates that Woolworths is losing competitiveness. Coles on the other hand, has improved its inventory turnover over the last couple of years.
To sum up, Aldi has already won the lower segment and will most likely take over a large part of the middle segment as well. In Germany, high-income customers also shop at Aldi. It is only a matter of replicating its success to the rest of Australia. It might take a long time, however. It has taken almost 15 years for Aldi to reach 10% market share. In Germany Aldi and Lidl have 25% market share.
What will change?
Woolworths overall trailing twelve months revenue fell in 1H15 for the first time ever because of the fall in oil prices. Food and liquor sales for Woolworths rose 1.2% YoY in 2Q15, the slowest pace since 2Q12. Trends look dire.
ROE is slowly falling, similar to what Tesco experienced from 2007 onwards. They may try to stop revenues from falling by remodelling stores, acquiring competitors but this will lead to a lower return on capital.
Gordon Cairns joined Woolworths as a new Chairman in September 2015. Gordon Cairns orchestrated the sale of David Jones, is a former boss of brewer Lion Nathan. The first priority is to find a new CEO with retail experience. It is unclear what his plan for Woolworths is, other than trying to prioritize customers.
Impacts on revenue:
- Aldi will spend A$700m on distribution centers and outlets to expand into southern and Western Australia. 120 stores will be built in Western and Southern Australia over the next few years. A 48,500 square metre distribution centre will be built at Jandakot Airport in early 2016, which will serve up to 70 stores.
- Aldi has set up a distribution system for fresh fruits and vegetables starting from 1H2015.
- In 2016, Aldi will launch 65 new stores, representing a 17% increase in Aldi’s store count vs current total of 372 stores. By 2020, Aldi plans to double its stores from 2014.
- Retail experts say the opening of an Aldi sees overall grocery prices drop by 6%. Media reports show that Woolworths and Coles are cutting grocery prices to reduce the 15 percent price gap with Aldi and increasing the frequency and depth of promotions.
- Aldi has recently improved its product range to include more branded products expected in Australia such as Nescafe, Vegemite and Milo as well as a wider range of meat and organic products and a better selection of bread
- Metcash recently announced a major turnaround strategy to expand private label and compete aggressively on price
- Higher end stores such as David Jones and Woolworths will most likely react by distancing themselves from the lower price end of the market through larger selections, new products and better service. Aldi’s market share gains will come from someone’s pocket however, and returns on capital for Woolworths must decline.
- Copying its strategy from Britain, Aldi will has begun to build four new “trial stores” targeting the middle market. In Britain Aldi drifted up-market through a better fresh-food offer, branded groceries and stores with improved ambience, shelving and lighting. Picture of one of the new Aldi stores:
Impact on margins:
- Moody’s estimates Woolworths’ food and liquor margins to fall from 8% in 2014 to 6.5% by the end of 2016 as it cuts prices on national brands and privte label groceries.
- Online grocery will eat into Woolworths’ margins as well. According to a McKinsey report, A shift from physical stores to online will reduce margins as retailers will have to take on the additional costs of labor and picking long before they can shed operating costs by shuttering physical stores. Woolworths online offering is said to be the best however. It is conceivable that it could take market share from others, such an impact may be small given Woolworths already-large market share overall.
- Aldi targets 2% EBIT margins, even though it has historically beaten its own targets. A 2-3% EBIT margin is however where Carrefour and Tesco margins have trended towards. Tesco margins reached 3.7% in 2013, recovered somewhat and are now negative after write-downs in 2015. Carrefour margins have fallen from about 4% to 3%.
Earnings forecast and valuation
Aldi is currently making sales of $6 billion a year. It plans to double its store count. Assuming sales/store is constant, another $6 billion in customer spend will have to come from other grocers’ pockets. Given a 40% market share, Woolworths will lose $2.4 billion over a five year period. With a 27% gross profit margin, Woolworths gross profit and also operating profit is likely to be impacted by $650m, or down 20% leading to a 4.5% operating margin in 2020.
In reality, the impact is likely to be larger. This is because of:
- Grocers will respond by cutting prices. Metcash has already stated it will achieve a turnaround by lowering its prices to the supermarkets it supplies. UK is an example of this: food price inflation has turned negative since 2014 eating into gross margins. No big signs of a price-war yet though.
- David Jones will open stand-alone upmarket food stores.
- The growth of online grocery shopping. Incumbents are usually not very good at responding to technological change. It is Ocado that is winning the online war in the UK and Amazon Fresh in the US – not Tesco itself or Wal-Mart.
On the other hand, private-label alternative Woolworth Macro may increase its market share as well, keeping sales in-house but putting a pressure on margins nevertheless.
I use the following assumptions:
- 2% increase in floor area per year
- 1% drop in sales/sqm per year, corresponding to a drop in line with Aldi’s projected market share increase
- 1% growth in SG&A per year, in line with deflationary wage climate
- Gross margin pressure: from 27.5% to 25.0% in 2017
All else equal, this leads to a drop in net profit of 40% from $2.45 billion in 2015 to $1.45 billion in 2017. That gives it a PE ratio of 21x, which is clearly far too high given the continued growth of low-cost alternatives over the next few decades. An EBIT margin of 3.5% and an EV/EBIT of 10x yields a fair value of $13.7/share. In an international context, an EV/S of 0.54x is still very unattractive, especially given the prospects of tougher competition ahead.
The drop in profit during 1HFY16 will likely be lower than for the same period in FY2015 due to falling oil price from autumn 2014. Consensus numbers for FY2017 calls for an 17% drop in net profit from FY2015. If sales/sqft fall as much as projected above, consensus profits will underwhelm even current low expectations.