An open letter to Woolworths CEO, Grant O'Brien

Dear Mr O'Brien,

After what has been a difficult period for Woolworths - which has seen the market de-rate the stock following the recent downgrade to FY15 NPAT guidance -  a lot clearly rides on the upcoming investor strategy day on May 6th.  You have drawn attention to subdued trading conditions in Food & Liquor, evident from as early as August last year, and confirmed by the marked slowdown in sales growth in the supermarket and petrol divisions for the latest calendar year (see chart).

You have also highlighted that General Merchandise continues to be affected adversely by the Big W business transformation, hotel earnings have been impacted by the additional Victorian gaming tax, while the expected timing of break-even for the Masters rollout continues to be pushed back.

The market's verdict in the past six months has been unequivocal; the price of Woolworths shares have declined by 10-15%, while the market has risen by around 5%.  Over the sweep of the past four years -  which coincides with your tenure as CEO - the performance of Woolworths shares broadly tracked those of Wesfarmers up until six months ago, at which point your shares have strongly underperformed not just Wesfarmers but also the ASX100 ex-financials and resources (the peer group which is used to benchmark hurdle rates for your senior executives' Long Term Incentives) - see chart.  Unless you can turn around expectations at the strategy day and the remaining two months of the financial year, Woolworths is set to miss the threshold for the Total Shareholder Return hurdle rate for the second year running (but more on remuneration later).

Even against a peer group of large global food & grocery retailers, Woolworths has been amongst the group of stocks that has delivered negative excess returns or alpha in the past four years (see chart).

The significant downgrade to analysts' EPS forecasts that has occurred in recent months largely reflects a re-assessment of Woolworths' ROE prospects.  Analysts are now projecting the company to achieve an ROE of below 22% twelve months ahead, well below the 25% they had projected as recently as in October last year (see chart).  This continues a trend of deteriorating ROE prospects that date back to 2011, when brokers were forecasting Woolworths to deliver an ROE of over 30%.

The deterioration in the marginal ROE from 2011 coincides with the rollout of the Masters Home Improvement stores, to the point where the marginal ROE has recently turned negative (see chart). 

In 2011, the proposed expansion into home improvement would have seemed a sensible strategy.  Wesfarmers had demonstrated an ability to successfully manage hardware stores and supermarkets, while the free cash flows generated from Woolworths supermarkets would effectively fund the roll-out of the Masters stores.

But the expansion into home improvement has clearly pulled down the profitability of the broader group and has distracted your (and other senior executives') attention from Woolworths' core supermarkets business, which has probably contributed to the marked slowdown in sales growth from that segment in the past year.  Moreover, few in 2011 expected investors to develop an insatiable appetite for income, that would see many companies defer or abandon growth options completely to cater to this growing demand for dividends. 

At a time when Australia's corporate sector is undergoing a demerger wave, spinning off non-core business assets, Woolworths has bucked the trend towards corporate focus by expanding organically into home improvement, where the synergies between running supermarkets and hardware stores are questionable (despite Wesfarmers' success in managing Coles and Bunnings). 

Drawing on international evidence, few of the largest globally food & grocery retailers run hardware stores.  Evidente's proprietary index of corporate focus shows that Wesfarmers and Woolworths are among the least focussed food & grocery retailers globally (see chart).  Corporate focus is but one of a number of factors that govern performance; indeed focussed firms like Tesco and Sainsbury have delivered dreadful returns in recent years.  Nonetheless, the missteps associated with the Masters rollout, deterioration in group profitability and ongoing adverse impact of the business transformation of Big W are clearly distracting you and senior management from Woolworths' core supermarket business.

Structure of financial incentives helps to ameliorate agency costs

Having read the Woolworths remuneration report in detail, as well as those of your peers both in Australia and globally, the key hurdle rates contained in the Short Term and Long Term incentives appear to be reasonable.  Contrary to conventional wisdom, I do not believe that the sales targets that form part of the STIs have unduly distorted executives' behaviour to chase sales at the expense of profitability.  Among the STIs, the hurdle rate at the group level is NPAT growth, while the divisional hurdles include not just sales, but also profit, return on funds employed and cost of doing business.

If I was to quibble about the remuneration structure, it would be the gradual lowering of the EPS growth hurdles in recent years that form part of the LTIs, from 10%-15% in F09-F11 to 6%-8%.  But this is not unique to Woolworths; other companies have also lowered their EPS growth hurdles in the face of persistent revenue headwinds in recent years.

license to operate not to be taken for granted

You would no doubt be aware of the Four Corners program (Slaving Away) that went to air on May 5th, which showed damning evidence of exploitation of migrant workers in Australia's fresh food supply chain.  The allegations affect most of Australia's stores that sell fresh produce to the public, including Woolworths, Coles, Aldi, IGA and others.  Four Corners has posted to its website the written responses from each of these businesses, including Woolworths.  Although each of the supermarket chains deals with hundreds, possibly thousands of suppliers, the big supermarket chains need to be careful about managing their reputational risk, particularly as the community and governments have effectively conferred a license to operate to Woolworth, Coles and other supermarkets.  The sheer size of Woolworths and Coles suggest that they have more to gain from leading the charge and ensuring that their suppliers do not engage in worker exploitation.  Thus any detail at the investor strategy day around your proposed pipeline of cost savings in excess of $500 million and expected impact on suppliers will need to be carefully communicated and managed.

corporate focus will be rewarded

I believe that investors will reward Woolworths if at the investor strategy day you articulate a vision and future for the company that has a renewed focus on its core business of supermarkets.  You have previously demonstrated an ability and willingness to sell under-performing non-core businesses such as Dick Smith.  Perhaps your greatest legacy to the company you have worked at since a teenager will be to have the courage to admit to past failures and exit home improvement, while re-assessing the synergies that exist between general merchandise and supermarkets.