Can Warehouse boss Powell deliver profits from new investments?

Warehouse Group [NZX: WHS], New Zealand's largest publicly listed retailer, expects its 'red sheds' to return to earnings growth next financial year as its store rejuvenation bears fruit and says the success of its drive to expand through acquisitions should be evident within three years.

Under chief executive Mark Powell, who notches up three years in the job next month, the company is investing $430 million over five years improving the quality of its private label brands, investing in staff and modernising the stores, in a bid to lure back customers and revive sales.

Powell says that two thirds of the way through the programme, the strategy is paying off with the 'red sheds' - its distinctive large store general goods format - posting 12 consecutive quarters of same store sales growth following seven years of decline.

"That's a big swing," Powell said on a tour of his store at the Albany Mega Centre. "We have got to put a lot of investment into the red sheds to turn around customer perception, invest in the stores, invest in the stock and invest in people. This is definitely starting to translate into increased transactions from more customers coming into store."

Still, analysts and investors say the store improvements and rise in sales have come at the expense of profitability, with margins and profits at the red sheds declining in the first half of this financial year. Powell concedes that the rise in sales hasn't yet translated into profits.

"It hasn't translated into operating leverage yet," Powell said. "The key word is yet. We would want to see it translating into operating leverage in the next financial year."

Powell says Warehouse had underinvested in its 92 discount stores in the past, refitting just 10 stores in the nine years before he took over, when it should have been upgrading 12 to 13 stores a year.

"We have had to make a big step to catch back up and it will drop down by the end of calendar 2015 to a normal rate," he said.

Powell is phasing out "cheap and nasty" private label brands for better quality products without raising the price after some products had a 20 percent return rate, damaging the Warehouse brand. Their Veon televisions are now the nation's highest selling by unit after replacing Transonic two years ago. Under the new regime, a product is pulled from sale if it has a return rate of 5 percent.

To improve customer service, Warehouse has undertaken what it believes is the country's biggest training programme of 6,000 employees, using actors to help staff understand what it feels like emotionally to interact with customers. Powell says he is avoiding short term benefits that could result from cutting staff numbers because unstocked shelves, unpriced products or longer checkout queues "insidiously eats away at the experience".

"The 'red sheds' is on a journey, it has taken a lot of investment and some heavy lifting after underinvestment," Powell said. "We have now really speeded that up, whilst improving the product, improving the experience. It has taken a lot of investment. I think we are directionally right but it is not translating into profit enough yet."

Analysts such as Nick Dravitzki at Devon Funds Management say the fundamental issue for the company is that it reached maturity as a discount retailer several years ago, as rivals such as Bunnings and Mitre 10 encroached into areas where Warehouse had been dominant. Meanwhile, Kmart and Farmers improved their competitiveness, and there is limited capacity for the company to expand its large-scale store format further.

But Powell rejects suggestions the 'red sheds' growth days are behind it.

"Red is not ex-growth at all, but the scale of growth wouldn't be what we would expect in some of the other businesses," he says. "Red is an important business. I will never accept it is mature. It will keep on evolving, but it is not going to be 20 percent growth or 15 percent growth."

The stores are likely to increase underlying sales 3 to 5 percent in the future, which should translate into operating leverage and profit, he said. He declined to estimate profit growth.

For the second half of the current financial year, Warehouse executives are keeping a watchful eye on unseasonally warm weather, concerned it may dent winter sales. Meanwhile, the second-most important event after Christmas, the six-week period leading up Easter Sunday, is going well so far, with confectionary sales from its Waikato Valley chocolate factory up 20 percent on last year, said Red Sheds chief executive Simon Turner.

To expand group earnings, Powell aims to grow the 'non-red' side of his business to be as large as the red sheds, though he says this is a long-term aspirational target, given red sheds have about $1.6 billion in annual sales compared to non-red at about $650 million.

Warehouse has failed at some of its previous attempts to grow outside of its core business with its unsuccessful move into Australia, where it bought two small discount chains and tried to expand them to compete with larger Australian rivals, and its recent flirtation with a supermarket offering.

Powell, who succeeded in improving the performance of the company's 'blue shed' stationery chain before taking the top job, is expanding the group through acquisition, buying 11 businesses in the past 18 months, adding technology and appliance retailer Noel Leeming, outdoor sports chain R&R Sports and online sporting goods retailer Torpedo7.

"In retail as a public company if you are not growing, you will end up in trouble," Powell said. "As a group, we have got to add value to anything we acquire."

Investors aren't yet convinced that the strategy will improve profits. Warehouse shares are the second-worst performer on the NZX 50 benchmark index this year, down 14 percent against the index's 7.5 percent gain. The stock is rated an average "sell" according to analysts polled by Reuters.

"Not too many people would disagree with the idea that you probably need to do something to the business now because it has been weak for a number of years," said Dravitzki, whose Devon Funds Management doesn't own the shares. "You certainly can't argue that they are not trying things, but the question is whether or not those things are successful and I think that thus far you would have to say that they are not.

"Some of the strategies make sense but won't all necessarily be successful or add value to the business," Dravitzki said. "It's a matter of looking for evidence that they are beginning to actually show some signs of traction. It's quite risky to imply into the price now significant value for these businesses that they have bought. "

Powell says he isn't planning any more significant acquisitions in the next year and understands that investors may be wary at this stage.

"We think we have done the right things, we don't think we have overpaid," said Powell. "I can understand people saying the jury is out because we are in the middle of that transformation. Two or three years from now you can say whether we are successful or not."

Devon's Dravitzki says Powell's attempts to grow the business are admirable.

"He deserves credit for being active," Dravitzki said. "I'm looking forward to being convinced that the things he is doing will be successful but we are not there yet in terms of evidence of that."

(BusinessDesk)