As a revitalised Coles goes from strength to strength, Woolworths has foundered amid missed opportunities and a lack of innovation. “It takes a long time to slow down the Queen Mary but once she is dead in the water she is awfully hard to restart”

Choosing the right hardware for growth

July 27, 2013

Katherine Jimenez


As a revitalised Coles goes from strength to strength, Woolworths has foundered amid missed opportunities, a lack of innovation and a misstep into the big-box hardware sector.

From the first day of Greg Foran’s appointment as Woolworths supermarket chief, one thought consumed his mind. He wanted to break Coles. The opportunity was there. Foran saw Wesfarmers’ $20 billion takeover of Coles in late 2007 as a perfect opportunity for the $40 billion supermarket juggernaut – once dubbed the ”Queen Mary” of grocery chains – to put its ”foot on the throat” of its arch-rival. Not long after his promotion in October 2008, Foran approached the then Woolworths chief Michael Luscombe and chief financial officer Tom Pockett with his grand plan. Having cut his teeth under highly regarded chief Roger Corbett during Woolworths’ golden years, Foran had pinched a leaf out of his book and believed the best weapon was to aggressively cut prices.He knew that the Coles business – acquired by Wesfarmers 10 months before the global financial crisis hit – was damaged and a significant strain on the conglomerate’s balance sheet. By dropping its prices, he believed an already fragile Coles would be forced to follow, which would thereby crunch its profits. Their largest competitor would be decimated.

‘You definitely feel Coles has probably led the way’ said a market analyst.

But Luscombe and Pockett were not convinced, preferring a more measured approach of matching prices. They wanted to maintain its impeccable record of delivering strong profits and saw being aggressively price competitive as the quickest way to hurt its own earnings.

”Woolworths had at that time achieved consistent double-digit profit growth for a decade,” said a former senior inside source.

”They weren’t prepared to compromise that record.”

But while the supermarket group appeared to be humming with big profits and sales numbers, critics say the course Luscombe had set the business on was causing damage in the long run. Loyal shoppers, who had become used to its everyday low prices, were turning away.

Within a few years the company would be issuing its first profit downgrade in nearly 17 years.

That early period following Wesfarmers’s takeover of Coles is seen by industry observers as the defining moment for Woolworths. It is seen as the start of when the Queen Mary lost her way – a period that culminated in last week’s admission by Woolworths that it had misstepped in its foray into the big-box hardware sector, dominated by Wesfarmers-owned Bunnings.

As Woolworths stumbled, Coles was revitalised under Wesfarmers and its hand-picked boss of Coles, Scottish retailing whiz Ian McLeod. Gone was the poor customer service. Stores were cleaned up. Stock availability was improved as was price perception. In just two years Coles was firing.

A crucial measure of Coles’ success can be seen in the key sales per square metre numbers. For more than a decade, the gap has been as wide as 25 to 30 per cent between the two. Analysts estimate that difference is now barely 5 per cent in Woolworths’ favour.

By the first quarter of the 2010 financial year, Coles’ comparable store sales for the first time in more than a decade eclipsed those of Woolworths. It has never looked back.

In stark contrast, the fortunes of Woolworths have been reversed. Detractors say it has lost its long-held market darling status, a status it won through years of outperformance and successful expansion into petrol and big-box liquor retailing with Dan Murphy’s.

Today, analysts point to the stall in sales in its core business – food and liquor – its lack of leadership in innovation, the disappointing performance of Dick Smith (which has since been sold), and more recently the issues plaguing its hardware business Masters.

Last week, Woolworths delivered the news that losses within Masters had ballooned from its initial estimates of $119 million to $157 million.

But more humbling was management’s acknowledgement that it was struggling with simple operational issues and did not fully understand the hardware business when it was setting its budget for the 2013 financial year. And despite Woolworths’ reassurance that the Masters business will break-even in 2015-16, at least one analyst was not convinced.

Following the market update on the hardware business, Citi analyst Craig Woolford wrote that he expected ”break-even a year later”.

”In our view, the sales per store needs to rise to $30 million to $32 million to reach break-even,” he said. ”This is equivalent to five consecutive years of comparable store sales growth of [between] 6.6 per cent and 7.9 per cent. Plausible, but a high hurdle.”

BusinessDay contacted several former Woolworths executives and observers for comment on this story. Most declined to comment due to Woolworths’ market clout.

But one source said: ”The investment community is starting to question their [Woolworths management’s] ability as retailers.” Some believe it could have been very different. Had Woolworths adopted Foran’s plan, they suggest its fortunes would be better than they are today.

One commentator said bluntly: ”Michael Luscombe and Tom Pockett will go down in history as those who set the strategy that facilitated the recovery of Coles and created the major challenges the company faces today.”

Woolworths disputes this version of history, and supporters of Luscombe and Pockett point to the solid sales and EBIT growth captured during their years, as well as the billions of dollars returned to shareholders in dividends and capital returns.

”Sales and earnings growth during Tom’s tenure speaks for itself,” a Woolworths spokeswoman said.

”[They] point to a company firmly focused at board and senior management level on generating high levels of growth above rates being achieved by most large companies.”

Woolworths also says that at the start of the Coles turnaround, a decision was taken to reduce prices – and quite significantly. ”We have always been about 1 to 2 per cent cheaper than Coles and this remains the case,” the spokeswoman said.

But former senior Woolworths insiders say that, up until 2010, Foran pushed senior management to take on Coles with his aggressive strategy but was repeatedly knocked back – creating tension between himself, Luscombe and Pockett.

”There was real tension around that,” a source said. ”Tom in particular was consistently saying no because Tom just wanted, by hook or by crook, the profit of the company to continue to grow, double-digit if possible. Clearly cutting prices was not consistent with that.”

Foran has since moved on to Walmart China and declined to comment, as did Luscombe and Pockett.

To appreciate the issues weighing on Woolworths today, it is important to understand the changes that took place between October 2006 and October 2011. The most controversial was Luscombe’s decision to steer away from the ”virtuous double loop” blueprint pioneered by Corbett – one of the two key strands of the former Woolies doyen’s formula for success. The double loop idea centred on having the lowest cost base and then passing a big portion of the savings to customers in so-called ”everyday low prices”. Woolworths achieved its low-cost base through its ground-breaking Project Refresh, which revolutionised supply chain and IT management. Of the $3.5 billion in cost savings achieved, more than half was returned to customers in lower prices, with the balance going to its bottom-line. The outcome was much higher sales.

The other strand was growth. By the time Corbett retired in 2006, Woolworths’ tentacles stretched across petrol, consumer electronics, liquor and general merchandise.

Those two vital strands, along with his leadership and vision, saw Woolworths transformed from a small supermarket business to a thriving retail conglomerate.

Nowhere was that vision best displayed than in its entry into liquor, especially in identifying liquor licences with large blocks of land nearby, which allowed them to establish their highly successful Dan Murphy’s stores. Under Corbett, Woolworths’ sales and profits more then doubled. By the time Luscombe became chief executive in May 2006, the company’s profit had lifted from $312 million to $791.6 million, and the shares had risen from $6 to $19.

The day before the announcement, Woolworths overtook Coles Myer as Australia’s biggest retailer in terms of sales.

The company’s profit growth surged in Luscombe’s early years, hitting 27.5 per cent in 2006-07 and 25.7 per cent a year later. But by financial year 2009 – after the financial crisis hit – it had cooled to 12.8 per cent, and by January 2011, Luscombe was forced to issue the company’s first profit downgrade in nearly 17 years.

A few months later, he stepped down. Foran was expected to get the top job; it went instead to one of his subordinates, supermarket chief operating officer Grant O’Brien.

One person who saw the path Woolworths was on early was Merrill Lynch analyst David Errington.

As early as May 2010 he penned a note titled A rock or a hard place where he outlined the issues facing Woolworths and warned that the company would struggle to generate double-digit earnings growth post the 2010 financial year.

He pointed to three fundamental strategic errors he believes management made: Its expensive store renovations, raising earnings before interest and tax (EBIT) sales margins aggressively, and its Qantas points loyalty program. Woolworths’ profit downgrade arrived less than 10 months after Errington’s note.

Soon after, former Woolworths chief finance director Bill Wavish wrote a scathing assessment of the Luscombe years in a note titled Double loop decay, as a guest author for investment bank CLSA. It was here that he referred to Woolworths as the Queen Mary, likening the group to the massive ocean liner.

He criticised Luscombe’s decision to drift away from ”its concept of first achieving cost savings and then sharing them with customers through everyday low prices”.

”Unlike the Corbett years, most shareholder gains come from increased gross margins rather than cost savings,” he wrote.

The effect of Luscombe’s decision to bank most of the savings, he claims, allowed it to rapidly ramp up its sales margins. In just six years, Woolworths’ EBIT/sales margin went from 4.09 to 6.5 per cent.

”By any measure the performance of Woolworths under Roger Corbett [and others] from 1999 to 2005 was a remarkable success,” Wavish wrote.

”In the ensuing six years the emphasis seemed to be on delivering value to shareholders ahead of customers. This opened the door for a revitalised Coles to take out its own costs and to assume the price leadership crown.”

It is these strategic errors, some say, that will now make O’Brien’s job harder. Although he is well regarded, one source believes that ”under Grant there hasn’t been much change because he has to protect the very high margin. That’s the key problem.

”Every day that you protect that margin, McLeod gets a free kick.”

The dilemma O’Brien faces, he points out, is if he drops the margin by 1 per cent ”that might be $300 million or $400 million of EBIT gone”. He also points out that management’s remuneration is tied to its earnings per share performance.

”They have to keep that margin high,” another source said.

”If they bring that margin down, they get slaughtered on an earnings [per share] basis.”

A further problem seen is that because Masters is struggling, it means the supermarket division has to keep its margins higher to offset the losses in the hardware business. By pushing margins up in supermarkets, that business becomes less competitive.

One analyst said: ”You definitely feel Coles has probably led the way and Woolworths has lost its position as the market leader in innovation and momentum.

”Can Woolworths again go forward? Potentially, but you obviously have got to get real momentum back.”

Analysts say the coming months will be crucial. One believes the priority is getting the hardware business right – or at least demonstrating that it is on the right track. ”That’s going to have to be demonstrated in the next six months,” he said.

Woolworths disputes talk it is not price competitive.

”All divisions are firmly focused on providing value and improving customers’ price perceptions of our offerings,” the spokeswoman said. ”Value is top of mind for Grant.”

So much so that in the public foyer of the support office – Woolworths head office – a large poster reads: ”On average only 50 per cent of our customers say we have the best prices. That leaves plenty of upside for 2013!”

Not everyone believes Woolworths is a challenged business.

”I think Woolworths is a great trader and I think Woolworths is on a growth cycle,” says Michael Lloyd, publisher of the trade magazine Shopping Centre News.

Lloyd points to Woolworths’ property portfolio and the work it is doing in researching how customers will want to shop online in the future.

He also believes Woolworths is showing innovation in its food business, citing its new sushi bars, cheese counters and sleek new butcher formats. They ”are not living on past glories”, he says.

Another supporter is former chief executive Reg Clairs who, although removed from the company today, remains a shareholder.

”From a personal point of view the things that interest me now is the price of the shares, and at $33 I am more than happy,” he says.

”And the dividends are very healthy and they continually provide a responsible profit. I’m not disappointed in the corporation.”

Woolworths itself insists there is plenty of upside in the business and ”many avenues for growth”.

”We are known for our strong core business in food and liquor, a cost-focused culture, strong customer focus and continuous business improvement,” said the Woolworths spokeswoman, while also highlighting that at the half year of FY13 it had already returned $2 billion to shareholders.

The spokeswoman also said it had a ”good handle on the challenges” facing Masters and that ”plans are in place to address them”.

Whether it can handle those challenges only time will tell.

At the conclusion of Wavish’s 2011 note he wrote: ”Negative trends are not always immediately apparent.

”In a business that thrives on daily sales feedback, there are also long-term trends. It takes a long time to slow down the Queen Mary but once she is dead in the water she is awfully hard to restart.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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