Woolworths Limited soars 8%, but is it time to buy?

Credit: Scott Lewis

Enthusiastic investors (or was it short covering) put a rocket under the share price of Australia’s largest supermarket operator Woolworths Limited (ASX: WOW) on Monday, sending the stock up 8%.

The rally appears to have been short lived however, with the stock sliding 3% in early morning trade on Tuesday.

What happened?

Yesterday, Woolworths announced to the ASX an ‘Update on Operating Model Review’.

The update outlined restructuring costs of close to $1 billion, the removal of 500 job roles, the closure of underperforming and unprofitable stores and the potential sale of its online store EziBuy.

While all of these “headline” initiatives will be dissected and analysed by investors in the coming days, cutting through the noise it was the disclosure of financial year underlying earnings before interest and tax (EBIT) which should arguably be the real focus of investors.

EBIT before one-offs and excluding the losses from the home improvement division has crashed by around 25% from $3.5 billion in FY 2015 to around $2.6 billion in FY 2016!

The decline can partially be explained by losses in the general merchandise division, which incorporates both the Big W and EziBuy brands, in the prior year this division was profitable.

By and large however it will have been declining profitability in the all-important food division which will be responsible for the earnings slump.

Buying opportunity?

While the write-downs and strategic review suggest a clean slate and an opportunity for the group to rebuild, it could be too early to buy in my opinion.

It’s not clear whether the strategic measures announced will primarily arrest the decline in earnings or actually set the group on a growth path.

Given there has been a halving in the store roll-out plan from a net increase of 90 stores over the next three years to a net increase of 45 stores, there is certainly a case for investors to reduce their growth assumptions.

It’s also worth noting that most of the measures are focused on costs which can improve margins and hence earnings in the near term.

Margin improvement is of course important, however long-term earnings growth – which is the driver of share price appreciation – will ultimately require sales growth.

Woolworths shares still look a risky bet

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Motley Fool contributor Tim McArthur 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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