1 stock you’d love to buy but shouldn’t

This company faces major challenges

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Woolworths Limited (ASX: WOW) has seen its share price fall by 17% in the last year.

That’s worse than the returns of retail-focused peers Wesfarmers Limited (ASX: WES) and Scentre Group Ltd (ASX: SCG). They are up 1% and 29% respectively. Although value investors may consider it a bargain, in my view Woolworths is not a ‘buy’ for these three reasons.

Cash flow

Woolworths’ net operating cash flow for the first half of the 2016 financial year fell by 16.9%. Despite this, it increased dividend payments from $798 million in the first half of FY 2015 to $819 million in the first half of FY 2016. Even on an adjusted earnings basis, Woolworths paid out 60% of earnings per share (EPS) as dividends during the period.

In my view, this indicates that Woolworths is more concerned with satisfying the income return of its shareholders in the short run, rather than in investing within the business to turn its performance around in the long run. Further, the current level of dividend is unsustainable on a cash flow basis. Woolworths’ free cash flow was $712 million in the first half of FY 2015, which is less than total dividend payments. Therefore, dividend cuts seem likely which could put its share price under pressure in the near term.

Strategy

Woolworths has sought to fight low-cost rivals on their terms, rather than on its own terms. In other words, it has lowered prices in an attempt to reduce the loss of customers to discount stores such as Aldi and Costco. As a result, Woolworths experienced average food price deflation of 2.1% in the first half of FY 2016.

Further, its $350 million investment in pricing since the first half of FY 2015 is more likely to reduce customer loyalty than improve it. That’s because competing on price makes it more difficult for Woolworths to differentiate on areas other than price versus rivals.

Although Woolworths maintained a high level of capex in the first half of the year and recently announced 500 redundancies as well as store refurbishments, the bulk of its spending centres on an investment in pricing. The end result was a 0.3% fall in sales in Q3, while net profit after tax declined by 33.1% before asset impairments in the first half of the year.

Outlook

The outlook for Woolworths is highly uncertain. It faces three challenges, all of which put pressure on its financial performance. Firstly, consumer confidence is not forecast to improve during the next year. Secondly, discount operators are increasing the size of their estates and will challenge Woolworths in a greater number of locations. Thirdly, Woolworths is in the process of changing its business model so as to exit home improvements and focus to a greater extent on its supermarket operations.

The combination of these three factors means that Woolworths’ outlook is very uncertain. Alongside its strategy and cash flow challenges, it means that Woolworths may be cheaper than a year ago, but it is not a stock to buy in my view.

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Motley Fool contributor Robert Stephens 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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