Earnings Risk For Woolies And Coles

This story features WESFARMERS LIMITED, and other companies. For more info SHARE ANALYSIS: WES

-Growth in space slows sales growth
-Earnings risk rising for major supermarkets
-Woolworths more exposed than Coles
-Discounters an increasing presence
 

By Eva Brocklehurst

Is an oversupply of supermarkets looming? Are the major operators, Wesfarmers ((WES)), in the case of Coles, and Woolworths ((WOW)) spreading sales growth ever more thinly? Brokers take a look at how the expansion plans of both Woolworths and Coles are shaping up.

Macquarie assesses the locations of 55 supermarkets that are planned in shopping centres across Australia over the next three years. The major supermarkets are aggressively engaged in this roll out, with both Woolworths and Coles outlining growth strategies. Woolworths expects to open 36 supermarkets in FY14, its largest annual roll out in over a decade, and Coles intends to open 70 new stores in the the next three years, 31 in Queensland.

Macquarie's analysis of the catchment areas for these supermarkets concludes that Coles supermarkets are larger and better placed. Macquarie calculates the average population per supermarket within the planned catchments is suitable for the expansion to be successful, at over 10,000 people per store on average. Coles has an average population per supermarket at 11,332 while Woolworths is lower at 10,546. Around 40% of Woolworths stores and 25% of Coles stores will be in catchments more likely to cannibalise sales from their respective networks, given existing stores are nearby. Still, on average, the broker believes the catchments will support the additional supermarkets.

Both companies are putting a greater focus on Queensland and the areas that are targeted have had higher-than-average rates of population growth since 2007, at 2.8-2.9%, versus the average population growth rate of the combined catchments of 2.3% and the national average of 1.7%.

Morgan Stanley crunches similar numbers but is not quite so confident. This broker goes somewhat further, in believing the current rate of space growth looks unsustainable. The chains have rolled out space well ahead of population growth for the past decade, which implies the catchment areas are shrinking. Here are some comparisons: In 2011 there were 2305 full line supermarkets servicing 22.3m people, or an average of 9,700 people per each full-line supermarket. To date, Morgan Stanley estimates these chains have added 246 net new stores, but the population has only grown by 1.2m. On this basis, each new store only services an average of 4,900 people.

Morgan Stanley expects like-for-like sales growth will slow as the major supermarkets accelerate the growth in space. The share prices of the two majors do not discount earnings risk, which Morgan Stanley thinks has risen significantly. The broker thinks the catchment quality is also declining. The acceleration in supermarket capacity has increased such that the majors will likely grow just 1-2% over coming years, forcing them to lift gross margins to sustain profits. Morgan Stanley observes that 65% of new Woolworths stores opened since 2011 have post codes which already contain a Woolworths store.

Reflecting on the UK experience, the broker notes British supermarkets effectively allowed discounters into the market by lifting gross margins and then rolling out more stores. While discount chains are thriving in the UK, major supermarkets are plagued by earnings warnings and price/earnings de-ratings. Ominously, Morgan Stanley envisages similarities with the Australian strategies. The broker lowers forecasts for Woolworths earnings in FY15 and FY16 by 4.5% and 6.3% respectively and retains an Underweight rating. Morgan Stanley considers Woolworths is the most exposed to a supermarket oversupply, as it generates the greatest proportion of earnings from supermarkets, has the most number and generates the highest margins. The broker thinks the earnings outlook will remain weak, as like-for-like sales growth fades, gross margin gains are less easy to achieve and operating leverage reduces.

The market may be focused on Woolworths' fledgling Masters home improvement business but of greater concern to Morgan Stanley is the reduction in incremental returns on the supermarkets business. Wesfarmers has not needed to follow Woolworths down the store roll-out path to the same extent but returns for Coles are not expected to be generated at the same rates as in the past. Morgan Stanley believes the current valuation of Wesfarmers discounts a slowing growth trajectory for Coles as space growth becomes the primary driver of sales. The broker retains an Equal Weight rating. Macquarie also finds neither stock particularly attractive from a valuation perspective, irrespective of store growth plans, and retains a Neutral rating on Wesfarmers and an Underperform for Woolworths.

What about online food & liquor spending? Morgan Stanley estimates that Woolworths and Coles will generate a combined $10bn in sales in the next three years. If online grows at 20% – growing currently at a rate of 26% – spending will grow to $4.5bn over the next three years. As a result, space growth needs to slow by at least 1% to avoid cannibalisation. Moreover, the broker does not think the majors can continue to take share from the Metcash ((MTS)) supplied independents forever. The independents' share will not shrink to zero as the broker believes some catchments, such as remote locations, are too small for a major supermarket to service profitably while planning restrictions in densely populated areas prohibit roll-outs of full service supermarkets.

Morgan Stanley doesn't write off the discounters either. Aldi and Costco are increasingly accepted as alternatives in Australia and both are accelerating store roll-outs. By 2020 the broker estimates that the number of Australians being able to shop at Aldi and Costco will increase to 50% and 20% respectively. The most exposed to Aldi and Costco among the established supermarkets is Metcash, particularly in Western Australia, where Aldi intends to roll out 60-70 stores. Metcash has 17% of its IGA stores in WA.
 

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