Investors too bullish on Coles and Woolies, says Morningstar

-- | 04/12/2019

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Glenn Freeman: In this edition of Ask the Expert" I'm speaking with Johannes Faul about the Australian supermarket stocks.

Johannes, thanks for your time today.

Johannes Faul: Hi, Glenn. How are you?

Freeman: Good, thank you. You've just put out this special report looking at the Australian supermarkets, Coles and Woolworths. What are some of the key points that you're bringing out there?

Faul: Look, I think what we did is, we had a very close look at our investment thesis and at the core that is really that the Australian supermarket sector has actually changed significantly when Coles and Woolworths both rebased their earnings about four years ago. And really, our thesis is that their profitability, the dollars that they earn per dollar of sales, isn't going to return to the golden days when it was almost like a duopoly like margin that they've earned. So, our view is that that has changed mostly permanently or at least for the foreseeable future with Aldi becoming a more dominant force in Australian food retailing sector.

So, we had a look at our thesis on margins at the evidence to-date and really what we've seen over the last few years is that both Woolworths and Coles have been successful in stabilising their profitability. So, margins have contracted and especially for Woolies, they haven't declined to the degree that we thought. We thought they will end up somewhere around the 4% mark. And Woolworths has been stabilizing them at around 4.7%, so slightly above, but still far cry away from the over 8% EBIT margin that they were earning at the peak.

Freeman: How long ago was that?

Faul: So that was about five years ago. What we're seeing now obviously that stabilization has really shown that even though Aldi is growing still, the growth is moderating and also, over the last few years combined Woolworths and Coles have maintained their market share. So, the two big players in that space have been successful in, if you like, defending their turf or holding their ground. Where the share has come from is mostly the independent network. So, if you think about the IGA network. With that note, with our research, we found that – and also, I guess, reexamine but also reconfirmed that Woolworths has a narrow economic moat and a larger competitive advantage over everyone else that Coles has and Woolworths also has that competitive advantage over Coles, which has no moat. And the reason being structurally why we think Woolworths has a moat is because of its scale. It just has greater cost advantages. And the cost advantages come from a larger sales figure over which they can then distribute and fractionalize their cost base which is quite similar to Coles. If you think about the overhead costs such as running advertising on TV and other things.

On the on the other hand, Coles has lost market share to Woolworths, although it also has successfully been maintaining its profitability. So, we think that the outlook now for Woolworths is much more stable given that price deflation is easing and for Coles, we just don't see that yet because they are still losing market share momentarily. Aldi has established itself in Australia. Its presence will keep prices sharp, will also contain EBIT margin. So, the operating margin, the profitability of Woolworths and Coles, the sales, at a sustainable level, but not at those record highs. For Woolworths, it was above 8% levels but more about 4%, 4.5%, that's basically now the range where we see the EBIT margins for both Woolworths and Coles.

This report appeared on 2022 Morningstar Australasia Pty Limited

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