Shares of Woolworths Limited (ASX: WOW) have been sold down heavily over the last 12 months with investors becoming increasingly concerned about its dominance in Australia's $88 billion food and grocery industry.
Woolworths, Coles – owned by Wesfarmers Ltd (ASX: WES) – and Metcash Limited's (ASX: MTS) IGA have all been locked in a pricing war whereby prices have been reduced considerably to drive sales growth. This has been exacerbated by the growth in market share enjoyed by international retailers such as Aldi and Costco, which have forced our local retailers to become even more competitive.
While a competitive environment is certainly good for consumers who benefit from lower prices on popular shelf items, the intensity of the price war is threatening to derail margins and profit growth across the industry which would certainly impact investors.
As highlighted by the Fairfax press, a new report by UBS says that the risk of a full-blown price war is growing – particularly since Woolworths announced a $500 million investment into its supermarkets division, aimed at lowering prices and driving long-term growth. It's likely that rivals will continue to lower prices in anticipation of Woolworths' price reductions which could further restrict profit growth across the entire industry.
Fairfax also quoted UBS which suggested a number of ways in which Woolworths can claw back market share whilst minimising the industry-wide fallout. Firstly, it needs to become more proactive in its marketing and sales activity – that is, learning what products the market wants and when it will want them – to attract customers before its rivals can do the same.
Meanwhile, UBS also urged Woolworths to dump its heavy promotions approach to instead focus on cutting everyday prices, which could help limit the extent of a pending price war. While this approach could hurt like-for-like sales growth in the near term, it could also help drive profit growth in the coming years.
Should you buy Woolworths?
Although Woolworths' ability to continue competing with its rivals in the long run is a justifiable concern amongst investors, the risk/reward profile for the stock has become much more attractive with the stock having fallen nearly 19% over the last 12 months to just $29.20 per share.
While the retailer's immediate future remains cloudy, Woolworths has time and again proven its ability to generate fantastic shareholder returns, and I expect that trend will continue over the coming years. The company's 4.8% fully franked dividend makes it an even more compelling investment opportunity.