Supermarket Tug-Of-War Continues

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Intense competition continues to plague supermarkets and brokers unravel the latest implications from food & grocery price surveys.

-Food price deflation likely to continue in the near term and Sept qtr growth driven by volumes
-Woolworths resists higher prices in fresh food while Coles discounts its packaged goods
-Citi queries and calculates sustainable margins for Australian supermarkets
 

By Eva Brocklehurst

Food prices remain weak, brokers observe, as the supermarkets continue to invest in price amid intense competition. Deutsche Bank believes Coles, owned by Wesfarmers ((WES)), is reinvesting the leverage from its sales growth, which makes regaining sales momentum more difficult for Woolworths ((WOW)). Aldi's rapid roll out in South and Western Australia adds another layer of intensity to the challenges.

On Credit Suisse's calculations, the growth rate in the supermarket industry was driven by volume in the first quarter of FY17. Price indices signal both Woolworths and Coles have experienced price deflation, year on year. The broker forecasts like-for-like sales growth of 0.3% at Woolworths and 3.8% at Coles in the September quarter.

Deflation at Coles did moderate. Online price indices signalled a fall to 2.0% deflation in the quarter from the 2.4% reported in the prior quarter. Higher prices for meat were the main reason deflation moderated, which partly offset lower prices for packaged goods.

Credit Suisse observes Woolworths has resisted raising prices in the meat category. Hence price deflation in the September quarter was 2.9%, high relative to Coles. and the supermarket appears to have aggressively discounted its fresh food categories.

The broker's in-store survey indicates the fruit & vegetable category at Aldi experienced high single-digit quarter on quarter price rises versus low single-digit increases at Coles and Woolworths.

Coles appears to have invested more heavily in packaged groceries, Deutsche Bank agrees, which is consistent with industry feedback suggesting it has become difficult for Coles to maintain sales momentum. The broker also observes Woolworths is investing heavily in meat, a key category as it is a driver of a larger basket size.

Overall, Deutsche Bank believes the market is becoming more competitive and expects deflation to persist. A situation where inflation returns to food is considered to be some time away as Woolworths' trading momentum is yet to turn around. Woolworths has demonstrated a willingness to invest incrementally and this could lead to further price deflation.

The broker adds that for branded and private label products, Coles has made a deeper investment in price compared with Woolworths. The difference is even more evident in premium products. Premium private label prices deflated 6.5% at Coles in the September quarter versus 4.8% at Woolworths.

Woolworths has begun phasing out its mid-tier Select brand to replace it with the Woolworths brand. Following its decision to discontinue the Homebrand label, to improve customer value perceptions, that product will be now be marketed under the Essentials private label brand.

On the other side of the tug-of-war the broker suspects Wesfarmers is employing the same strategy it has used across its other retail businesses, that is to reinvest the leverage from its sales back into price to make competitor growth more difficult. Deutsche Bank points to Bunnings and Kmart, suggesting that, if executed correctly, the successful business pulls further away from competitors with increasingly cheaper prices and stronger sales growth.

From the perspective of Deutsche Bank's survey, food pricing trends were largely unchanged in the quarter and there was 0.3% inflation. Food prices have now been very weak for six quarters. The broker estimates fresh food pricing deflated 0.7% in the quarter compared with 1.8% in the June quarter and, as is usual, this was driven by fruit & vegetables. Meat & seafood prices increased 0.5% at Woolworths while at Coles these prices rose 4.1%.

Citi undertakes a comparison of Australian supermarkets with the UK, noting that Tesco recently stated it aims for margins of 3.5-4.0% by FY20, up from 1.7% reported in FY16.

While the broker acknowledges comparing margins across retailers can be difficult, adjusting by excluding fuel, the FY16 EBIT (earnings before interest and tax) margin for Coles is calculated at 5.3% and Woolworths at 5.0%. This compares with 1.4% at Tesco.

As the difference in property ownership across the three is stark the broker prefers a comparison of EBITDAR (earnings before interest, tax, depreciation, amortisation and rent) margins. On this basis, Coles sits at 10.4%, Woolworths at 9.8% and Tesco at 5.4%.

In comparing the enterprise value/EBITDAR ratio of each retailer the broker makes a rent-adjusted calculation. Using FY16 results the outcome suggests Tesco trades at 7.1 times, Wesfarmers at 8.1 and Woolworths at 6.2.

Should Australia have higher margins for its supermarkets? Australian retailing is more consolidated, and while store formats and cost structures are similar, planning laws are more restrictive and population growth is higher. In sum, Citi believes profit margins should be around 100 basis points higher for Australian supermarkets compared with the UK.

Margins for Coles are expected to fall slightly but not collapse in the near term and the broker does not envisage a price war will be forthcoming. EBIT growth at Coles is expected to be subdued and this is the main reason Citi has a Sell rating for Wesfarmers.

FNArena's database shows one Buy rating (Macquarie), six Hold and one Sell rating for Wesfarmers. The consensus target is $42.71, suggesting 5.6% downside to the last share price. Targets range from $38.80 (Citi) to to $45.00 (Ord Minnett). The dividend yield on FY17 and FY18 forecasts is 4.5% and 4.8% respectively.

For Woolworths, there are three Hold and four Sell ratings. The consensus target is $21.06, suggesting 12.9% downside to the last share price. Targets range from $18.85 (Macquarie) to $24.79 (Morgans).
 

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