Since its inception in 1931, the Woolworths Group has become one of the leading and most recognisable retail brands in South Africa. Over the years the company has managed to retain its competitive edge, in part through innovation, but also through strategically diversifying its core businesses.
Part of this diversification included expanding the Group’s geographical exposure, and in 2014 Woolworths deepened its Australian presence through the acquisition of the retail department store, David Jones. In the time that followed, the acquisition proved to be a poor capital allocation decision for the South African business. David Jones underperformed the Group’s expectations, draining essential resources from the broader business, mainly through cash that was being generated by Woolworths South Africa, but also through redirecting management’s attention away from the South African businesses. The combination of these factors negatively impacted the Group’s earnings, thereby placing significant pressure on its share price.
At the same time, inefficiencies were starting to emerge within the Group’s South African businesses, affecting mainly Woolworths’ Fashion, Beauty, and Home (FBH) division. Change was needed, which eventually came in the form of incoming CEO, Roy Bagattini, and the appointment of a number of new board members. Upon taking office, Bagattini set to work on strengthening the company’s senior management team and embarking on a three-fold strategy to turn the business around. His success in this space proved pivotal for the business, and today Woolworths is on a sustained path to returning to its former glory, as an operationally efficient and highly cash-generative business, with an attractive earnings outlook.
Over the course of this article, we’ll take a closer look at the strategies that Bagattini and his management team employed to turn the business around, and the reasons why we believe Woolworths has the potential to add value as a key holding within our 4 Factor equity and multi-asset portfolios.
Our investment philosophy – the lens through which we evaluate the companies we hold
When assessing the relative attractiveness of a particular company, we evaluate it through the lens of our investment philosophy: earnings revisions at reasonable valuations.
More simply put, we look at the forward earnings of a company relative to its share price and the implied valuation, taking a 12 to 24-month view. Our preference is to invest in companies where we believe the market has underestimated its future earnings, and where the valuation of that company is reasonable in our opinion.
Woolworths is one such company that fits this mould. The Group’s future earnings and returns profile has been revised higher, largely due to the success of the company’s three-fold strategy, which essentially focused on the following:
- Separating the two Australian businesses and disposing of the Group’s holdings in David Jones
- Stabilising and fixing the South African FBH business
- Improving the Group’s financial health by restoring its balance sheet
Success within these core areas ultimately led to operational efficiencies, reduced debt levels, and improved sales, all of which improved the earnings for the business relative to market expectations. When coupled with the company’s current valuation, which we believe to be reasonable, Woolworths appears to be an attractive and compelling investment opportunity. But to fully appreciate the investment case for the Group, it’s important to have context of its recovery story.
An Australian story – the David Jones saga
The background
When Woolworths initially acquired David Jones, the Australian retailer was an ailing business. However, Woolworths management at the time believed that the department store would serve as a key differentiator for future growth, in addition to making the Group the biggest retailer in the Southern Hemisphere.
This, however, didn’t turn out as expected, and the acquisition ended up causing a strain on the Group’s balance sheet, and consequently, the overall profitability of the broader business. During this time, Woolworths was supported by its more stable food business in South Africa, which saw the company essentially using the cash generated domestically and allocating it to David Jones in Australia.
In addition to David Jones becoming a financial strain, it was also taking away management’s ability to focus on innovation and operational efficiencies in South Africa. This came at a time when the domestic retail market was becoming increasingly more competitive, with the likes of the Shoprite Group turning its focus away from the Rest of Africa towards more local ambitions.
A new way forward
In 2020, Roy Bagattini was appointed as the new Woolworths CEO. Under his leadership, the Group embarked on an ambitious campaign to unbundle David Jones from its holding company, by selling properties that David Jones owned and separating the retailer’s operating systems from the Group’s other Australian business, the Country Road Group (CRG). By 2022, the Group had successfully separated the two Australian businesses, after which it entered into an agreement to sell its entire stake in David Jones to an Australian private equity fund. The disposal of the company and its associated properties heavily reduced the Group’s debt levels, as shown in the below graph. Markets understandably responded positively to the news.Figure 1: Net debt pre IFRS 16 leases
Source: Company reports, FY2023 results, 30 August 2023
Domestic focus – implementing widescale improvements
The background
Domestically, the Group’s FBH business remained relatively stable, however, because management’s attention was focused on building up David Jones, few improvements were made to the profitability of the FBH business.
Enhancements on the horizon
Following the sale of David Jones, Bagattini and his management team turned their focus to South Africa where they primarily looked to build up efficiencies across the Group’s FBH operations, reduce costs, and increase profitability. They did this in three ways:
1 Firstly, they closed suboptimal spaces to improve sales density. This essentially meant reducing the amount of space that was not being used to generate sales.
2 Secondly, they improved the ‘availability of product’ – which included building greater efficiencies in the supply chain, thereby allowing stores to have the right merchandise in stock, in the correct quantities. Although this is still a work in progress, it’s encouraging to see the Group having committed significant capex over the next three years (R10bn in total), with a material proportion of that allocated to the supply chain for FBH and its food business. As shown in the below graph, the combination of reducing non-revenue generating space, while increasing sales densities – saw a sharp improvement in profits generated per square metre, which is a key driver of higher profit margins.
Figure 2: Woolworths FBH: Sales per sqm vs EBIT per sqm
Source: Ninety One and Company reports, FY2023 results, 30 August 2023
3 Lastly, through improvements in sales density and supply chain efficiencies, the business was able to increase its full-price sales contribution, as products resonated more with consumers.
Figure 3: Woolworths fashion, beauty and home businesses
Source: Company reports, interim FY2023 results presentation, 1 March 2023
Focus on earnings – Woolworths has improved materially
The cumulative effect of the company’s management team achieving their objectives improved the Group’s earnings potential. Today, the business is well-positioned to see a positive change in its free cash flow generation, especially following the disposal of its David Jones business, which historically contributed negatively to free cash flow.
Looking forward, the Group expects the profit margin for its FBH business to increase to 14% by FY2025, all of which points to a remarkable turnaround in just a few years.
Figure 4: Fashion, Beauty and Home (FBH) EBIT margin sees continued uplift
Source: Company reports, FY2022 results, 31 August 2022
In conclusion, we believe that the Group’s positive earnings revisions will become a sustained trend due to the improvements made to its FBH business, in addition to the better growth generated from the Group’s food business as it regains market share.
There are some headwinds to note, mainly in the form of CRG and the potential drag on near-term earnings as the Australian economy slows down, although we are confident in the long-term growth story. Woolworths is also not the cheapest stock in the sector, but we think that the valuation is reasonable considering the Group’s earnings profile, plus the uplift in returns and free cash flow generation following the disposal of its David Jones business. The disjoint between the Group’s earnings revisions and its share price presents us with a compelling opportunity to increase our stake in what we believe is a quality business.
Woolworths represents a remarkable turnaround story and its earnings revisions and valuation fits firmly within our investment philosophy. The future looks promising for the Group, and we are confident that holding the share on behalf of our clients will contribute positively to portfolio returns going forward.
