Australians are returning to supermarket shelves to find their go-to fresh foods have leapt in price. Vegetables and beef and veal are up 12.7% and 12.1%, respectively, over the past twelve months. But what’s bad for consumers is good for supermarket giants Coles and Woolworths, as growing inflation boosts sales as prices rise. The question for investors is how long this trend will last?

Speaking to Morningstar, equity analyst Johannes Faul expects rising grocery prices to boost supermarket earnings in the near term. However, he warns the boost to earnings is “temporary” as inflation tapers off, leaving Coles and Woolworths overvalued.

Faul forecasts prices will moderate from fiscal 2023, with food price inflation expected to average around 2.5% over the subsequent decade. 

“Food price inflation is well and truly underway in Australia and we continue forecasting supermarket shelf prices to rise by mid-single digits in the second half of fiscal 2022,” he says.

“We expect these abnormally high price increases to bolster supermarket earnings in the near term, offsetting the rising cost of goods sold, higher energy prices, weak population growth, greater out-of-home food consumption, and temporarily bloated supply chain costs because of COVID-related disruptions and demand volatility.

“However, we forecast this tailwind to moderate from fiscal 2023, with food price inflation averaging around 2.5% in the subsequent decade. The Australian government expects inflation to moderate over the medium term too.”

On a relative basis, Faul prefers Coles over Woolworth, but both supermarkets are overvalued with fair values of $25 and $13.60 respectively. Coles closed on Wednesday at $18.71 and Woolworths at $37.68.

“Current share prices suggest the market is more optimistic on the profit outlook for Woolworths and Coles. However, we expect structural challenges to limit their sales and earnings growth at around 4% over the next decade,” he says.

If a prolonged period of inflation occurs, Faul says this could drive greater sales and earnings growth and present an upside risk to fair value. But, he anticipates stubbornly high inflation--above the Australian Reserve Bank’s 2%-3% target range--to trigger interest rate hikes and weigh on price to earnings ratios.

Over the year, the prices of grocery foods as measured by the consumer price index (CPI), jumped 5.3 per cent from a year earlier. That contrasts with more modest inflation for meals eaten out and takeaway food, which rose 2.6%.

Fruit and vegetable prices combined rose at an annual rate of 6.7% due to “Covid-related supply chain disruptions, and high transport and fertiliser costs”, according to the Australian Bureau of Statistics. The prices of non-durable household products such as cleaning and personal care products jumped 8%, much greater than the CPI rise of 5.1%.

Grocery products, quarterly and annual movement

Source: Australian Bureau of Statistics

Higher prices for goods do not automatically expand supermarket margins. While prices are rising for consumers, so are the input costs for supermarkets, including wages, energy and supply disruptions. The question is whether supermarkets can pass on inflationary pressures to consumers that exceed their input costs, and whether consumers will respond by continuing to buy goods at the same quantity and rate as they did before prices rose. This is a relatively safe bet as ‘grocery’ is a non-discretionary category – people must eat – but preferences may change.

Price competition between stores is also important. For example, discount stores help prevent the larger chains from increasing prices too far.

Morgans analyst Alex Lu also believes Woolworths is fully valued but has a positive outlook. He says Woolworths delivered a commendable third-quarter sales result despite operational challenges related to Covid-19, supply chain bottlenecks and widespread floods in eastern Australia.

“With food demand being relatively inelastic, we think the company should continue to perform well in a higher interest rate environment. However, trading on 27.6 times fiscal year 2023 price-earnings, and 2.6% yield, we see Woolworths as fully valued,” says Lu who has a ‘Hold’ rating on the stock.    

As for which supermarket is performing stronger, Faul says that for three consecutive quarters, narrow-moat Woolworths has outperformed Coles in sales growth and gained grocery market share.

“The sales of the group's core Australian food segment—which we estimate to account for 86%of operational earnings in fiscal 2022—increased 5% in the third quarter of fiscal 2022, assisted by bourgeoning shelf price inflation. This compares with 4% sales growth at no-moat Coles' Australian supermarkets for the same period.”