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A Masters class for investors

I’m sorry uni students, but you’re wasting your time. The same goes for all of us who took a few years at the end of high school to get a tertiary qualification – at least since the federal government introduced the HECS and HELP schemes that required those attending university to contribute towards the cost of their education.

We’ve all wasted our time – and most importantly our money – apparently.

At least, that’s the only logical conclusion one can draw from the market’s reaction to Woolworths’ (ASX: WOW) market update last Thursday.

Positive signs

The retailer tightened its profit guidance range to the higher end of previously announced growth. Originally to be between 4% and 6%, that number is now estimated to be between 5% and 6% when Woolies announces its final results. So far, so good.

But what really seemed to upset the market was one of two things: either investors were hoping Woolworths was going to upgrade guidance above that 6% mark, or – much more likely – they were reacting to the additional information Woolworths provided about its nascent home improvement offering, Masters.

Enter, learn, consolidate, profit

First, a bit of background. Not that many years ago – well, more than I’d like to admit, because it makes me feel old – Woolworths and supermarket rival Coles were much smaller players in the grocery market. They had maybe 40% market share (compared to their current levels closer to 85% in some grocery categories). The sector was state-based and fragmented, with lots of little supermarket brands, competing wholesalers and lots of inefficiency.

Fast forward those 30 or so years, and we now have a consolidated grocery market with just Woolworths, Coles and Metcash’s (ASX: MTS) IGA stores as serious competition. The same happened with bottle shops and is happening with petrol stations.

Coles’ owner Wesfarmers (ASX:WES) is already on the march in hardware/home improvement with its Bunnings chain, but with only 16% of the market, according to Woolworths’ announcement, there’s a lot of room for a large second player to help consolidate that market.

A large, growing market is exactly what Woolworths needs, as its grocery domination means market-beating growth will be difficult to achieve with baked beans and frozen vegetables from here. Overseas expansion, while always an option, has its own risks. Perhaps it was inevitable that Woolies entered the home improvement market – and it has the additional benefit of potentially distracting Wesfarmers’ management away from its resurgent Coles business.

For what it’s worth, while the latter makes for a nice story, I don’t think Woolies really expects that Wesfarmers can’t walk and chew gum at the same time – but it would certainly know that any time spent on a Bunnings defence against Masters is time not spent on the supermarket division.

An investment in the future

Now back to last week. Woolworths released detailed numbers on its Masters business for the first time, and in the process disclosed that it had missed some of its internal targets last financial year, particularly its expectations of product mix and sales margins. For the record, Woolworths’ hardware division turned in sales of $1.24 billion, and an operating loss of $139 million, compared to an $81 million forecast loss.

The question for investors is how big a deal is that miss really is. And, other than for short-term traders who were maybe expecting better things, the answer is really, as the kids these days say, ‘meh’.

Not so fast

In context, the $58 million ‘miss’ by the hardware division (which includes Woolworths’ hardware wholesaling business) is the equivalent of little more than a rounding error on the Woolworths profit and loss statement.

For long-term investors, the real question is what the numbers mean, if anything, for Masters’ long term future – and the answer is neutral at worst. With such a small number of stores opened, relative to a final number that’s likely at least 10 times the current store count of 15 and the company still working out the right product and pricing mix (as well as infrastructure, supply and marketing), investors should be simply shrugging their shoulders.

The real question for investors is whether, with 84% of the market fragmented and ripe for consolidation, Woolworths can carve a sizeable and profitable niche. History, as well as Woolworths commitment, should suggest that such an outcome is far more likely than not.

Foolish takeaway

The current losses are simply upfront investments in what is likely to be a much longer term success story. It’s the equivalent of the university student who gives up three years of full time work and pays HECS/HELP – likely putting themselves deep into the red – to prepare themselves for a bright (and higher income) future.

For university students and investors alike, there’s little to be gained from an obsessive focus on the short-term – especially when it has little to do with the long-term future. A company prepared to invest today for a brighter future tomorrow is exactly the sort of company you should want to own.

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Motley Fool investment analyst Scott Phillips owns shares in Woolworths.

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