Masters to drag Woolworths down

Woolworths’  (ASX: WOW) earnings estimates have been downgraded by Merrill Lynch, with the broker expressing concerns over the Masters joint venture with US hardware giant Lowes  (NYSE: LOW).

David Errington from Merrill Lynch has estimated that the company’s earnings before interest and tax (EBIT) will be below 5% for the next four years, in comparison to its 2007 year in which the company’s EBIT was approaching 25%. The poor outlook on the coming years is largely driven by the poor performing Masters business.

Masters Home Improvement was intended to increase Woolworths’ competitiveness with rival Wesfarmers’ (ASX: WES) Bunnings Warehouse – whose properties are predominantly owned by BWP Trust (ASX: BWP), formerly Bunnings Warehouse Property Trust.

Instead of earning profits, experts are now predicting that the joint venture will result in a total loss of $830 million for Woolworths over the next four years – with as much as $265 million expected to be lost in the 2015-16 financial year.

The Australian reported that Masters generates gross margins of 42%, which is significantly higher than Bunnings stores, which generate 32%. However, it is the company’s “inhibitively high” costs per store that are causing such high losses.

Woolworths, on the other hand, is pleased with the progress of Masters and the stores’ current results, based on the number of stores it currently has compared to the number it intends on having in coming years. The company has stated that the joint venture was expected to lose money until the 2015 year, when it will have more stores and greater efficiencies. Woolworths further stated that the Masters business was “on track to achieve a break-even position by 2015-16”.

After shares hit an all time high of $36.84 per share last week, analysts are also expressing concerns about Masters stores. Citi analyst Craig Woolford stated that continual poor performances from Masters “may weigh on the stock”.

Foolish takeaway

Whilst Masters is currently accruing heavy operating and administrative costs for Woolworths, it is expected that, as the business grows, so will the revenues and profits. Its high gross margins are certainly a good sign, and Woolworths should be able to recognise significant growth from the joint venture over time.

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