Woolworths should exit its chronically underperforming businesses in Australia – David Jones and Country Road – and list its extremely profitable South African food business separately, says a just-released report by Salmour Research.
The report states that the beneficiaries of this strategy would be the shareholders who “over the past five years have experienced substantial value destruction”.
They estimate the market capitalisation of ‘Woolworths Food’ could be just under R50 billion, which is around 95% of the group’s current JSE market cap.
The authors of the report, Rod Salmon and Chris Gilmour, estimate the extent of value destruction, since the A$2.1 billion acquisition of Australia-based David Jones in 2014, at between R34.9 billion and as much as R79.7 billion.
The latter eye-watering figure is based on assumptions about how well Woolworths would have continued to do if management had not been distracted by its disastrous Australian adventure.
The authors acknowledge that their assumptions rely on the benefit of hindsight but contend that they are made with a view to the future.
Because they see no sign of improvement, the R79.7 billion figure emphasises the urgent need for the Woolworths board to take decisive action.
“Considering the trend of Woolworths’ management in reducing the medium-term returns’ expectations for the David Jones business and the longer-term downward performance trend around the world for the department store format, an improvement in the David Jones business is, in our view, highly unlikely.
“There is still in our view a real risk of damaging the core South African business further, both in trading and in investor perception,” says the report.
Close to R80bn explained
Salmon and Gilmour come to the R79.7 billion figure by extrapolating the average headline earnings per share growth of the Woolworths business between 2008 and 2014, a period that included the global financial crisis.
This growth was an impressive 17.1% per annum.
“Being conservative and taking half of this growth rate, and extrapolating it to the present day, would suggest that earnings for the South African business in 2019 would have been at least 50% higher than that of the combined business and in 2020, allowing for a further 50% reduction on 2019 earnings for the Covid lockdowns, HEPS [headline earnings per share] would have been, in our view, at least 130% higher,” says the report entitled ‘Woolworths – Breaking up is hard to do’.
The hard-hitting report recounts how the original ambitious plan to create a southern hemisphere retail giant was upended by the reality of the stark differences between Australian and South African consumers.
Instead of taking the Woolworths concept to Australia, the David Jones department store format ended up in South Africa.
Everybody was dissatisfied. Except perhaps the executives and directors.
Despite the decline in headline earnings per share, the report notes that “the base pay of the senior executive team increased on average by 111% and total remuneration by 54%.”
In addition: “The board which oversaw the purchase of David Jones saw remuneration increase by over 90% over this time.”
Looking back to the time of the investment, Alec Abraham, a senior analyst at Sasfin, explained to Moneyweb this week that then-CEO Ian Moir had demonstrated an ability to convert brand equity into shareholder value within a few years at the helm of Woolworths.
It was almost inevitable that he got backing for his Australian plan.
“At the time it sounded very compelling, we were told the same sort of brand equity was involved in the two countries and that they planned to take the David Jones brand label from 2-3% of sales to 30%. The idea of a mighty buying machine in the southern hemisphere was very attractive,” says Abraham.
All in all, forecasts of operating profit margins of over 10% at David Jones seemed reasonable.
The flaw in the plan
However, what management, analysts and investors didn’t realise, say Salmon and Gilmour, is that consumers in South Africa and Australia have considerably different fashion tastes and quality expectations.
“We believe that the Australian consumers saw most of the South African product as inferior in quality and/or potentially off-trend.”
It certainly didn’t help that in Australia the Woolworths name is linked to a low-end retail chain.
And in South Africa the David Jones brand failed to get consumer support.
Asief Mohamed, CIO at Aeon Investment Management, tells Moneyweb that at the time the problems for Woolworths’s South African clothing operation were exacerbated by the dramatic increase in competition from a slew of international operators such as H&M, Zara and Cotton On.
“Initially the plan sounded exciting but it quickly became apparent that the strategy wasn’t appropriate and certainly wasn’t working,” says Mohamed.
Seven years later the forecast for David Jones’s operating profit margin is just 4-5%, which is lower than the 2014 level.
Dumping Australia is a strategy now backed by most analysts and investors but, as Salmon and Gilmour acknowledge, might prove challenging.
The authors put forward four options which have varying degrees of attractiveness:
- The most attractive would be a merger with (Australia-based) Myer to create one Australian department store group;
- The next most attractive would be to demerge and separately list the Australian businesses on the Australian stock market;
- The third option would be to sell the businesses, which would be difficult and would have to involve incentives but would be better than the fourth option, which is:
Salmon and Gilmour believe Woolworths’s board is preparing to exit the David Jones business – but not Country Road Group – noting that its lending requirements have been separated from the group, that properties have been sold and the business is, for now, cash positive.
Easier said than done?
But implementing any decision will be difficult because the David Jones deal was proportionately so large for Woolworths.
Mohamed reckons the sale of David Jones has been on the cards for some time but publicly confirming it would affect the price.
He also questions why Woolworths is even in the clothing business in SA but acknowledges it would be difficult to spin it out of the food business in the short term because they are both so intertwined. For now, the best they can do is continue to reduce the clothing floor space.
Abraham believes that as long as Woolworths doesn’t have to fund David Jones there is no urgent need to sell it; meanwhile management should continue to focus on reducing its Australian cost structure and sorting out its South African clothing businesses.
Moneyweb contacted Woolworths for comment but the group declined, noting that it could not comment because it is currently in a ‘closed period’.
Next week’s Woolworths results presentation may shed some light on what plans the board has for recouping some of its shareholders’ lost value. Or not.