Why I think Woolworths Limited is no longer a blue-chip business

Australian investors need to overcome their anchor bias and realise that Woolworths Limited (ASX:WOW) is no longer a blue-chip stock.

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The two worlds of investing and psychology influence each other, and often do so in ways that surprise even experienced market participants like those who read this website.

A generation of investors have become accustomed to a small basket of "rock solid" "bottom-drawer" "blue chip" stocks. And standing tall among those blue chips was Woolworths Limited (ASX: WOW). Along with stellar year-on-year capital growth, the company also rewarded investors with a steadily growing dividend.

And while it was easy to attribute the fantastic success of the company to the oversimplified "everyone has to eat" argument, the success of Woolworths was actually much more complex.

As a part of the landmark Project Refresh, Woolworths pioneered the double loop strategy. This involved completely overhauling the supply chain that spanned the country, and finding cost savings and efficiencies.

These cost savings were then ploughed into relentlessly lowering prices, at precisely the same time as Woolworths' major competitor, Coles, was undergoing management upheaval and changing ownership.

But that was almost 20 years ago, and along the way, some things went wrong.

The Fixed Costs Problem

A national supermarket has a huge fixed cost base. The concept can be illustrated using a simplified example. A busy local supermarket serves 100 people a day, and earns $2,000 in revenue. All of the fixed costs that relate to keeping the doors open (staff, electricity, water, taxes, etc) amount to $1,500, which results in a profit of $500.

But to serve 200 customers a day (or 100% more customers) the fixed costs do not rise anywhere near that much. In fact, they only rise by 20%, meaning the local supermarket makes $3,400 in profit daily ($4,000 in revenue less $600 in fixed costs).

But in the opposite situation, if customer numbers fall, the fixed costs don't fall much at all. That means the supermarket is earning less as it cannot cut its expenses at the same rate as falling revenue to maintain profits.

This example shows precisely why Aldi, along with the better marketing and execution of Coles are such a problem for Woolworths. The total number of customer visits, or foot traffic as management calls it, is in decline. This is a result of negative price perceptions where a large percentage of Australians believe that Woolworths is the most expensive of the national operators.

But like the local supermarket from the example, it cannot cut fixed costs sufficiently to make up for the lost revenue, and Woolworths' fixed costs are much higher, and on a national scale.

The Panic Button

That is what has seen the company hit the panic button and announce a $500 million investment in lower shelf prices in an attempt to coax back customers.

But this strategy was tried by a company with a similar business model to Woolworths in the United Kingdom, without much success. Tesco Supermarkets invested an even higher amount in cutting shelf prices in an attempt to woo back customers that were lured by the lower prices of competitors, including Aldi.

While Tesco had many other problems at the time, the strategy failed to arrest falling sales and earnings, and the company's share price followed the declining profits down.

A Bleak Outlook

Woolworths' management has scrambled to address the falling earnings before they become entrenched. But it should be noted that the current negative impacts have been felt before Aldi has a single store in South Australia or Western Australia. The German discounter is moving to plug these holes in its store network.

In addition Lidl, the other German discounter that has joined Aldi in stealing up to 20% market share in the UK, is about to enter the Australian market.

Put together, these moves could spell even more trouble for Woolworths' already declining market share and profitability.

Foolish takeaway

Woolworths has been a blue-chip stock for almost two decades. But the past is no indication of the future, and the fundamental changes in the Australian grocery supermarket and missteps by management mean that earnings for the supermarket chain are unlikely to grow strongly in the near future.

That means that profits, dividends and the share price are all under pressure, and is also why Woolworths is no longer a blue-chip stock in my opinion.

Motley Fool contributor Ry Padarath has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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