Diminishing Food Inflation Sounds Alarm Call For Supermakets

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-Sharp inflation decline in March
-Severe in terms of packaged grocery
-Prospect of a price war
 

By Eva Brocklehurst

Food inflation, or a lack thereof, is fast becoming an issue for Australian supermarkets. Citi believes so, given soft commodity prices are weak even when viewed in Australian dollar terms.

The Australian dollar has fallen by around 18% over the past year, the broker observes, but soft commodity prices have fallen further. Sugar prices are down 33% in US dollar terms, palm oil is down 34%, wheat down 27% and dairy 29%. Citi maintains the global slowing of emerging market demand and favourable global growing conditions are at the heart of lower pricing. Citi’s food inflation indicator, based on a weighted basket of softs, is highly correlated with shelf price growth. Citi calculates that Australian food inflation has fallen to around zero from 2.0% within six months.

What may change this scenario is any drought or flood impact on fresh categories but at the moment, these factors are benign. Suppliers may be expanding margins which could materialise as product innovation and retailers may also be expanding margins. Still, the latter Citi considers is highly unlikely, given Woolworths ((WOW)) plans to step up promotional intensity over the next three months. Citi considers the need to lower private label prices to compete with Aldi will reduce profit margins over the next three years.

Deutsche Bank also conducts a supermarket study which suggests pricing trends were weak over the past three months. Fresh food inflation was modest but packaged grocery items deteriorated. The severity of this deterioration increased mid March and stemmed from price investment by Woolworths, which the broker observes was implemented via offers on both branded and private label products. Rival Coles, which belongs to Wesfarmers ((WES)), did not make price changes to the same degree while the IGA network, supplied by Metcash ((MTS)), recorded price inflation.

The supermarket inflation index in the broker’s study follows prices of seven discrete baskets of 100 goods across the thee major supermarket chains. Deutsche Bank tracks prices weekly but notes inflation is difficult to measure because of the complexities around promotion. The broker believes the indices published by major chains over-emphasise the promotion impact because they use a moving basket. In contrast, Deutsche Bank uses a fixed basket of goods to understate the drag from promotional substitution and believes this is a good directional indicator of the trend.

The March quarter revealed 2.2% price inflation, only slightly above the prior quarter’s 2.1%. Moreover, packaged grocery inflation slowed considerably, notwithstanding a continued weakening in the Australian dollar. Fresh inflation was also soft but the broker acknowledges this cycled strong fresh price growth in the prior corresponding quarter. Still, weaker packaged grocery pricing is a significant negative, more so than fresh, given elasticities are much higher in fresh produce and consumers have a propensity to substitute.

On average in the quarter, Woolworths’ branded products increased 1.9% year on year compared with 4.4% for Coles. Notably, Woolworths branded products were in deflation for the last three weeks of March. Deutsche Bank construes this as evidence for the start of Woolies’ $500m price investment. The broker expects Coles to eventually retaliate as these offers from Woolies persist and the prospect of a price war and consequent decrease in profitability is concerning.

What about IGA? The data suggests solid price inflation, partly because of the cycling of a period of deflation in the prior corresponding quarter. Deutsche Bank was still surprised at the extent of IGA price inflation but believes Woolies’ decision to invest in price will have an adverse impact, given it makes a number of the Super IGA price match actions redundant.

Metcash and Woolworths both derive around 80% of their earnings from supermarkets. As Metcash is primarily a wholesaler, it has a lower cost of doing business and its operational leverage is higher than Woolworths. Coles has the highest leverage to marginal increases in the top line, in Deutsche Bank’s observation, given a higher cost of doing business, but it constitutes 45% of Wesfarmers’ earnings and the mix of other businesses dilutes the positive impact that inflation can provide.

Deutsche Bank has a Sell rating for Wesfarmers with a target of $39.25. This compares with other brokers on the FNArena database where the targets range from $39.25 (Citi) to $44.34 (Macquarie). There are no Buy ratings on the database, with five Hold and three Sell. The dividend yield on FY15 and FY16 forecasts is 5.3% and 5.2% respectively. The consensus target is $42.44, suggesting 2.3% downside to the last share price.

This compares with Woolworths, which also has no Buy ratings. It has three Hold and five Sell. The consensus target is $29.39, suggesting 1.0% upside to the last share price. Targets range from $24.00 to $32.94. The dividend yield is 4.7% and 4.8% on FY15 and FY16 forecasts respectively.

Metcash has one Buy rating, four Hold and three Sell on the database. Targets range from $1.30 to $2.90. The consensus target price is $1.96, suggesting 38.7% upside to the last share price. The dividend yield on FY15 and FY16 forecasts is 9.1% and 8.7% respectively.
 

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