Bare shelves only a short-term hit to Coles and Woolies

Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Joining me today is Johannes Faul. He is a Director in our Equity Research team.

Johannes, thank you very much for joining us.

Johannes Faul: Thanks so much for having me, Emma.

Rapaport: Johannes, I think you would have noticed as much as anyone else in Australia or anyone specifically in New South Wales that a lot of supermarket shelves have been bare. I'm particularly thinking about fresh fruits and vegetables, meat, things like that. So, I wanted to get your take as an analyst for both Coles and Woolworths about what this means for the stocks and for the long-term outlook of the sector. I want to first get your thoughts on – for me, this feels like it's not necessarily the same as the supermarket panic buying that we saw in early 2020, but a very different sort of shortage. Can you explain quickly why we're seeing empty shelves in our supermarkets?

Faul: Yeah, absolutely. Well, one thing that's a bit of reminiscence of back then is toilet papers is hot commodity again. Never would have thought that we'd see that again. Yeah. So, this time around, it is a bit different, as you say Emma, and what it is, is this time we're having supply chain issues. And what's happening is, a lot of people can't show up at work, or couldn't because they're isolating for whichever reason. Those supply chain issues should hopefully alleviate over the next couple of weeks. And that's also the guidance that we've been hearing out of management from Woolworths. So, we'll see those shelves a bit empty for a few more weeks, but then we should hopefully return to fuller shelves.

Rapaport: As an analyst for Coles and Woolworths, is this something that you're worried about, something that you're looking at or something you're worried about for reporting season come next month?

Faul: Yeah. So, reporting season coming next month will be the first half of 2022, and we hadn't seen the issues that we're really seeing today in January. They weren't really impacting up until maybe late December when it started. So, we haven't really had that in that first fiscal half. But for the second fiscal half of 2022, it will have an impact. And the impact that it will have is, on one side, there's a lot of demand. That's the positive side. The negative side, though, is that it's very, very disruptive. These supply chain issues are very disruptive to supermarket operations, and they're disruptive in store, but they're also disruptive on the warehousing side, on the delivery side, on the trucking side, so all through that chain, throughout value chain. And if you think about supermarkets, it's a really, really well run, well-oiled machine. It's running on very skinny profit margins. It's a problem having those inefficiencies. So, all up, on balance, this is probably a negative for the second half of fiscal 2022. But then, it's temporary. As I say, we're expecting a lot of this will be over that hump in the next couple of weeks and then things will normalize. So, it will be short and severe, but it won't impact the long term, and it won't impact our long-term outlook on earnings, and our investment thesis still stands for Woolworths and Coles.

Rapaport: Do you expect that this could lead to any sort of food inflation for the supermarket sector? Or as you say, will it be a very sort of temporary thing?

Faul: That's a really, really good question, and that's something that's more underlying and something that's happening more fundamentally than just these more severe supply chain shortages or supply shortages that we're seeing, and that's inflation. And on the inflation slide, even before this all started, we saw inflation returning. So, we are predicting, or we're estimating that inflation for the December quarter has actually returned.

So, what happened going back a few quarters is we saw a lot of food price inflation when COVID first emerged in 2020. Then in 2021, in calendar 2021, we had the last three quarters up until the September quarter, we saw food prices actually deflating, so prices being lowered. And now, for the December quarter, we're expecting Coles and Woolworths both to report food price inflation. So, that's actually already changed before the supply shortages emerged. And for this quarter, we would expect that's going to get another big boost from what we've been seeing. Longer term though, we see food price inflation here to stay, not rampant, not in the mid-single digits, but in the low-single digits and stay there pretty much with what you'd expect on like a long-term consumer price inflation or CPI.

Rapaport: Yeah. And just quickly to round out, both Woolworths and Coles are currently screening as overvalued stocks and have had a relatively difficult last month as well. Could you just quickly sum up your outlook for both stocks and why you see it both of them as not been great buys?

Faul: Yeah. Both of them, if you look at their price to earnings ratios or multiples, they're sort trading at fairly high multiples, even despite this slight correction we've seen in last few weeks, and my anticipation is that that's mainly driven by the operational challenges that we're seeing at the moment. But if you look at it more fundamentally, those high P/Es basically mean there's growth expectations in there. The market has growth expectations in terms of earnings growth for both Woolworths and Coles. And we don't see a lot of earnings growth happening, and we don't see them becoming dramatically more profitable over the next decade, and we don't see a lot of top-line growth. We expect the top-line growth, so the revenue growth for both supermarkets really to be driven by population growth, and as I just mentioned, a low-single digits CPI figure. Now, that outlook for earnings growth doesn't really warrant the current multiples they're trading on. So, all up, the supermarkets still look expensive. On a relative basis, Coles is more attractive than Woolworths. So, as an investment we would prefer Coles over Woolworths at current prices.

Rapaport: Great. Thank you so much for joining us today.

Faul: Thanks a lot, Emma.