Woolies’ Struggles Against Interloper Are Just Beginning

By Roger Montgomery | More Articles by Roger Montgomery

As a consumer I love it when Woolies offers lower prices. If I was still an investor in the shares of the company, I’d be much less sanguine.

Since Montgomery sold its Woolworths shares in November 2014 — above $30 — the stock has been in decline. At around $21 today, the share price could represent an opportunity to make a lot of money or an opportunity to lose a great deal more. To help resolve the dilemma, it’s worth briefly understanding how Woolies arrived at this position.

The primary cause of Woolworths’ woes is the arrival of Aldi. A further contributor is corporate governance, although there is only so much even the best oarsman can do if his boat has a leak. Aldi makes a profit globally on a 2.5 per cent margin for earnings before interest and tax. Not long ago Woolworths was reporting 8 per cent margins. Aldi can operate and expand on 2.5 per cent margins because it is simply a more efficient business.

When Aldi enters a new country, it only does so if the salaries of the employees in that country are very high. Why? Because it gives the company an immediate operating advantage. That’s the only way its model works. You see, an Aldi supermarket might have three employees in a store of the same footprint that Woolies requires 30 people. Aldi can operate with less staff because its promise is to offer the best price, not the biggest range. Where Woolies might have 30 tomato sauce products, Aldi has just one. That means it has better buying power for that tomato sauce than Woolies and Coles, even though the incumbents have enjoyed 80 per cent market share and Aldi just 10 per cent.

With fewer individual products needing replenishing on the shelves, fewer staff are required to operate the business. Aldi doesn’t enter a country unless it displays high average gross domestic product and high wages. Ideally it also likes to find territories where there isn’t already a hard discounter established. Then Aldi rolls out its 20-year plan.

Aldi is a debt-averse business and so it was always going to grow slowly because it needs to buy sites and build stores. When it gets to 350 stores, and about $3.5 billion in sales then the company is in a position to source its products locally. It is then the biggest purchaser of the products it is interested in. It then buys local and at a cheaper price than Coles and Woolies. It also demands the recipe it wants and it starts hitting Australians’ taste and quality expectations.

What can Woolworths do? To begin, they are now playing by Aldi’s rules. Their first return volley was to “invest in lower prices”. This is a euphemism for cutting prices (and cutting profits for shareholders, by the way). Woolies is discovering that it’s simply not working and they have now reported four quarters of negative same store sales growth.

Some analysts believe Woolies will recoup the lost margin from suppliers because the volume has gone up and that it will cut staff costs. But customers have long complained there aren’t enough staff in the stores so if staff are cut, presumably customer satisfaction will decline further. And whenever Woolies cuts its prices, the others, including Aldi respond meaning it will have to continue “investing” in lower prices. Nowhere in the world have incumbents survived the entry of Aldi with their margins intact.

Woolies will survive, but Aldi is here to stay and Woolies must be a smaller business (spinning off Big W, exiting Masters) and/or report lower margins and profits.

Roger Montgomery

About Roger Montgomery

Roger Montgomery is the Chief Investment Officer of Montgomery Investment Management, montinvest.com, and author of blog.rogermontgomery.com. Alan Kohler has referred to Roger as "one of the nations smartest and most successful value investors".

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