Woolworths has remained a near to naked underweight on our watchlist for some years. Despite its apparent quality, brand, scale, and returns, our portfolios have avoided its underperformance. Our concerns centered on uncertainty around how the company could defend its incumbency against a revitalized Coles and emerging Aldi. Last week Woolworths provided a market update under new CEO Brad Banducci. This included a further almost $1b significant charge, reflecting restructuring costs and asset write-downs. This covered impairments, store closures and provisions for onerous leases. These are mainly the result of failed attempts to expand margins and grow, with sales insufficient to generate adequate returns on investment. Weak sales performance was in turn caused by a weak customer proposition with stockouts, poor servicing, and an unclear value strategy. FY16 EBIT guidance was issued and was below consensus. There were some positives as well - read on to find out more.

Some of the positives included;  improving customer and staff engagement scores, continued positive transaction growth, and items per basket turning positive in June. Importantly, Woolworths halved its planned new store openings over the next three years in favour of more refurbishments of existing stores, and has changed management KPIs to focus on sales per square metre and returns on funds employed. These are changes that investors have long been asking for.

Item growth has only turned up for two months and price deflation is expected to continue in the short term. Therefore the key sales productivity measure (sales / square metre) will remain challenging and threatens further operating deleverage and declining profits. Whilst encouraged by the positives, we are yet to be convinced there is a compelling retail execution strategy. We are therefore not sure management will be able to win back customers from Coles and Aldi. If not, the key overarching risk re-emerges which is further price and refurbishment investment, which the balance sheet will struggle to fund.

We have reduced our underweight position across our portfolios. This reflects the abovementioned progress, and with the stock trading near 10 year lows compared to the market, it is relatively attractive on our base case valuation. Backing out simplistic valuations for Wesfarmers' other businesses, suggests their Coles division is being priced by the market similarly to Woolworths, which is a much larger business than Coles.

Woolworths' competitive advantages of footprint, operating scale, product and price range, and convenience mean material upside opportunity is available. To realise this management must stabilise sales performance without large scale price investment, and continue the new focus on operating the business for the long term rather than short term profit outcomes. With over 40% upside if this occurs in a market where valuation opportunities are increasingly concentrated, we will continue to research and analyse management's progress.

Written by Jakov Maleš, Head of Equities, UBS Australia. Contributed by UBS Australia:  (VIEW LINK)


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