Supermarket behemoth Woolworths Limited (ASX: WOW) could be facing a bill of more than $1 billion should it choose to cut the prices of its private label grocery brands in response to fierce competition.
In a recent update to the market, Woolworths' management team admitted to making mistakes with its supermarket strategy which has seen the division consistently underperform its primary rival Coles, which is owned by Wesfarmers Ltd (ASX: WES). Its high grocery prices and mediocre customer satisfaction levels aren't helping the situation with low-price competitors Costco and Aldi now also posing as key threats to the retail giant's dominance in Australia's $85 billion supermarket space.
As was recently highlighted by my colleague Mike King in his excellent in-depth analysis of Woolworths' woes, Woolworths maintains significantly higher margins than Coles in its Food and Liquor division. In order to become more competitive and strengthen its brand image, Woolworths will need to cut back its margins to pass greater price reductions onto customers.
Source: Annual reports
Woolworths will adopt a new 'Lean Retail' operating model, which it established following a company-wide strategic review, which it believes will deliver more than $500 million of cost reductions across the 2015 and 2016 financial years. It will pass these savings onto customers in the form of lower prices, improved service and better convenience, but some analysts suggest that won't be enough.
As highlighted by the Fairfax press, a recent analysis of 20 home brand products undertaken by Morgan Stanley showed that Aldi's prices are 21% more expensive than Woolworths' budget Homebrand range, but a staggering 27% cheaper than Woolworths' Select brand. Meanwhile, Coles' brand prices are, on average, 34% cheaper than Select products.
Woolworths itself has even admitted that Aldi brands are "seen to be on par or better than Woolworths Select and better than Homebrand."
Indeed, private label sales are an important component for all supermarkets as their cheap prices draw customers into their stores, but further reductions could come at an enormous cost to Woolworths' overall earnings.
According to Fairfax, Morgan Stanley showed that a 10% reduction in Select products could result in a $388 million reduction in earnings before interest and tax (EBIT), while a 30% reduction across its Select products would hit EBIT by as much as $1.05 billion. By comparison, total EBIT from its Australian Food and Liquor division were just under $3.3 billion in the most recent financial year.
Of course, there is no certainty that it will cut prices that dramatically, while lower prices would also attract more customers. But Woolworths' shareholders shouldn't be surprised if the retailer's margins do contract in the near future.
Should you buy Woolworths?
The market has certainly recognised the headwinds facing the business which, together with its struggling Masters Home Improvement division, have acted as a weight on the company's share price. In fact, the stock recently hit its lowest price in more than two years and is now trading at $28.10 – a 28% discount to its $38.92 recorded just over 12 months ago.
Although the near-term outlook remains unclear for the retail behemoth, 'Foolish' investors should see this as an opportunity to pick up a high-quality business at a reasonable price. The changes being made by management appear to be in the best interests of long-term investors, which should see it get back on track in the not too distant future.
