With Woolworths Limited (ASX: WOW) falling by 21% in the last year, many investors may wonder whether now is a good time to buy it. After all, this year has seen it hit 10-year lows and this could indicate that it is cheap and may be rated upwards over the medium to long term.
Masters exit
Its decision to exit the home improvement space is a good one in my view. The sector is dominated by Wesfarmers Ltd (ASX: WES) owned Bunnings, which commands a market share of around 20%. Woolworths has invested heavily in its Masters brand but has not been able to make it a success and with its main supermarket business struggling, it seems logical to dispose of non-core assets such as Masters to focus on its core grocery business.
Convenience stores
I'm also upbeat about Woolworths' plans to move into the convenience store market. In the UK, the likes of Tesco and Sainsbury's have enjoyed huge success in diversifying from hypermarkets into the convenience store space. Such an offering is aimed at an increasingly time-poor consumer and should benefit from a tailwind in terms of an ageing population and a larger proportion of urban dwellers. With the convenience store industry estimated to be on a growth path to be worth around $4.5 billion by 2021, there is clear growth potential for Woolworths in this space.
Investment in pricing
However, I'm less optimistic about Woolworths' plans to invest in pricing. In other words, it is attempting to discount to see-off competition from no-frills operators such as Aldi. For example, Woolworths has invested over $400 million in pricing since H2 2015 and yet continues to report falling sales. They declined by 0.3% in Q3 2016 and the strategy Woolworths is pursuing on price is playing into the hands of Aldi and others in my view. That's because I feel that Woolworths is not differentiating itself sufficiently in order to win or even keep customers, but is merely reducing margins and overall profitability.
Weak cash flow
The growth of Aldi is likely to continue and so Woolworths' cash flow could come under even more pressure. Dividends have already been cut to $0.86 per share in FY 2016 from $1.39 per share in FY 2015 (a fall of 38%). However, Woolworths' free cash flow stood at $1.2 billion in FY 2015 and yet the company still paid more than this in dividends. It paid out over $1.5 billion in dividends, so it is perhaps unsurprising that dividends have been cut and additional cuts may be necessary to prevent further downgrades to the company's credit rating following S&P's downgrade of Woolworths to BBB from BBB+ in May.
Outlook
Although Woolworths is seen as a defensive stock with a high yield by many investors, I think there are better defensive stocks such as CSL Limited (ASX: CSL) and superior income plays such as Telstra Corporation Ltd (ASX: TLS). And while Woolworths' exit from the home improvement space and its move into convenience stores are sound moves in my view, its poor strategy on groceries, weak cash flow and the level of competition from discount operators makes its future uncertain.
