Is Woolworths a buy?

Leading retailer Woolworths (ASX: WOW) held its Annual General Meeting (AGM) yesterday. As Motley Fool analyst Mike King wrote here, management was forced to defend its move into the hardware sector, given the losses the Masters Home Improvement business has endured.

Woolworths has already spent around $1.5 billion taking on the Wesfarmers (ASX: WES) owned Bunnings chain, by rolling-out the Masters’ retail footprint. Having also endured significant start-up losses, which won’t end until 2016 – when management expects to achieve a break-even result – some shareholders are understandably concerned.

Given the structural shift towards online sales, the significant investment in ‘bricks-and-mortar’ is all the more concerning. As Chief Executive Officer Grant O’Brien noted, Woolworths is “unquestionably the largest Australian and New Zealand online retailer with 42% growth in online sales from continuing operations for the year.” The strong growth in online, has put Woolworths on track to achieve more than $1 billion of online sales in the current financial year. Woolworths isn’t alone in experiencing fast growth rates in their online divisions and all investors are right to question any retailer that continues to spend shareholders’ money on further investment in physical assets.

The Potential

What the future holds for Masters is hard to know, but what is certain is that shareholders require a decent return on invested capital. Given that Bunnings has only around a 16% share of the hardware market, there is certainly the opportunity for Masters to win market share. Likewise, given Woolworths’ experience in retailing, the business will likely trade profitably at some point in the future.

Being sceptical and cautious as an investor can be a good thing and for this reason watching from the side lines and judging the success of the Masters strategy – with reference to returns on capital – could make sense.

Foolish takeaway

While Woolworths’ share price has underperformed both Wesfarmers and the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) in the past 12 months, the stock still trades on a full looking 17.7 times price-to-earnings. While a well-executed Masters’ strategy could certainly provide upside and earnings growth, there is also risks to the downside, which would make overpaying for Woolworths unadvisable.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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