3 reasons to avoid Woolworths Limited shares

Credit: Scott Lewis

A lot has been written of the challenges facing the likes of Woolworths Limited (ASX: WOW) as it battles to fend off competition from Coles and Aldi.

As a stock, I don’t find Woolworths compelling enough today to consider it worthy of new money, and there are three main reasons for this:

  • Woolworths’ gross margins at above 7% can only go one way

Woolworths’ gross margins at 7% or so have a long way to fall as it ‘invests’ in lower prices to compete.

Wesfarmers Ltd (ASX: WES), which owns Coles, has just as much to fear from Aldi as Woolworths from a market-share perspective, but probably won’t feel the pain of competition as much as Woolworths due to Coles’ lower margins (around 4%).

Lowering prices is a clear acknowledgment by Woolworths’ management that the threat is real. As margins fall, so will net earnings which is why the market has already de-rated the stock.

  • The growth of Aldi

Aldi is growing like a weed and has recently started operating in South Australia with 20 stores and has an expected 20 or so stores to commence operations in Western Australia by the end of 2016.

With continued growth in eastern Australia, the Aldi store count is expected to reach 476 by year end.

Given this growth in store numbers, Aldi’s share of the national grocery market is to rise from 7 percent to at least 10 percent by 2019-20 according to UBS. What this means for Woolworths, Coles and Metcash Limited (ASX: MTS) is the loss of at least $1 billion in sales between the three.

Not only is Aldi increasing its store numbers nationally, it is doing so by controlling costs. The fact that Aldi has a much smaller range of products means it can negotiate better prices with suppliers leading to lower prices for consumers, Aldi’s key competitive advantage.

The result is that Aldi is thriving and challenging the incumbents meaning lower market share being held by Coles and Woolworths in the years ahead.

  • Capital allocation

As a former shareholder of Woolworths, I wasn’t impressed with the way the Masters roll-out was progressing. I eventually decided to sell my shares (fortunately, north of $34) as more news came out at how badly the Masters chain of stores was bleeding the whole company.

There are a whole host of reasons for the Masters debacle, but probably the major problem with the strategy was that the Woolworths board and management, in my opinion, had little to no entrepreneurial experience in starting and growing a business.

It’s all fine and good for the rest of the Woolworths business to subsidise a start-up, as Masters was, but being a public company, it was only a matter of time before management’s hand was forced by shareholders to do something.

Foolish takeaway

I see no catalyst in the short or medium term for a re-rating of the Woolworths’ share price. Rather, in the medium term, Woolworths’ market share and margins will continue to fall resulting in a less-profitable business going forward.

Although it’s possible falling margins and market share will plateau at some point in the future, the immediate term is not great. With an expected fall in earnings and dividends of 15.6% and 15.8% respectively over the next two years, investing in Woolworths today is the antithesis of a good investment.

Now that Mr Brad Banducci has replaced the former CEO, Grant O’Brien, there’s hope that at least Woolworths’ capital allocation may improve, but unless there’s a positive change in Woolworths’ prospects, I see no reason to buy or hold on to these shares at current prices.

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Motley Fool contributor Edward Vesely has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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