Coles, Woolies and shareholders facing tough facts

-- | 20/02/2019

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Johannes Faul: Long-term thesis in supermarkets is that there's structural headwinds on top of also cyclical headwinds. And structurally, really what's happening is the competition has stepped up in that increased competition is here to stay in the form of Aldi and going forward, you are going to have another hypermarket entering the Australian market in the form of Kaufland.

So, that's going to happen in the next couple of years. And Amazon is already here with their pantry offering online, putting pricing pressure on those products. And also, longer-term, there's a risk that they might roll out their fresh offering in Australia.

So, that's just from a competitive environment what's happening structurally. But on top of that also, the common theme around retail is that you see the consumer moving online and what that means for supermarket retailers – or food retailers such as supermarkets is that it's quite costly selling these lower-valued items and a bunch of them, picking them, packaging them, delivering them, that's quite cost-intensive. Which means that online sales right now are dilutionary to EBIT margins.

And look, across the last two days, obviously Coles reported and also Woolworths today. And a common theme across both of them, they are experiencing very strong online sales growth with 30 per cent online sales growth.

But these sales are just barely breaking even in our view and therefore, really weighing on margins.

And what we've seen with Coles' margins in food, they are down slightly year-on-year or half-on-half.

And for Woolworths, again, just up a little notch but essentially flat margins. So, we are seeing that despite, like, they are getting growth coming from the top line, that margins aren't heading anywhere.

Another risk to Woolies' margins – EBIT margin in food is that they are going to have an increase in the wage structure coming in as of January. So, for the next half, we expect those margins to come off as well just in line with what Coles has been seeing.

So, I think, what the market has really been looking, or hoping, for at least for Woolworths, in our mind, is an expansion of EBIT margins.

So, that explains a high P/E multiple and that premium to the market that Woolworths has been trading on. But essentially, now, for the half they reported virtually flat EPS growth, so low-single-digit EPS growth which doesn't really warrant such a high valuation multiple in our mind.

And even after the sell-off that we've seen today in Woolworth's shares, we still think shares are overvalued at these prices. And if you think about those two very similar businesses, very similar strategy, structurally, they are in the same market facing the same headwinds, Woolies arguably and the cost advantage of Coles is just giving the scale in sourcing their product.
But in reality, you look at what those two companies are doing, the growth segments that these companies have, and they are very, very similar. So, in our view, Coles would be much more attractive investment on a relative basis to Woolworths at these price levels.

This report appeared on 2022 Morningstar Australasia Pty Limited

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