Supermarkets are taking their lumps – Is it justified and what's the investment case?

Amid the cost-of-living crisis, few businesses have been cast as villains quite like the supermarkets.

They have drawn consumers’ ire, and the recent move by the ACCC to sue Coles and Woolworths for allegedly offering “illusory” discounts (i.e., putting up prices only to cut them later and claim they are being offered at a discount) has only added fuel to the fire.

Whilst we’re not here to prosecute the supermarkets (we’ll leave that to the ACCC), we are here to get perspective on how the big supermarkets (particularly Coles (ASX: COL) and Woolworths (ASX: WOW)) operate, the conditions they are operating in, and how the investment case stacks up.

To do that, we engaged Bruce Smith, Principal and Portfolio Manager at Alphinity Investment Management, who has been covering the consumer space for 20 years. He offers a unique perspective in the following Q&A. 

1. Over the journey,
Australian supermarkets have enjoyed some of the best margins in the
world, and it seems that is the case again today. How have you seen
margins evolve since you have been covering these stocks and how are they able
to maintain them?

Margins are a little higher here than in some places in the world but not massively so. Just because a margin is a bit higher doesn’t necessarily mean people are being ripped off, it could just be that some companies with lower margins have structural or management challenges. 

Woolworths NZ for example, had an EBIT margin below 2% last year, but not because consumers are getting a really good deal over there. Coles and Woolworths Australia are both large, reasonably well-run operations that have invested a lot of their shareholders’ capital in the stores and logistics. 

They need to earn a reasonable return on that investment to be able to retain the support of shareholders so they can keep spending capital on logistics, maintaining stores and providing services people want, like online shopping, in the future.

We met with Loblaw in Canada recently. It faces a lot of the same challenges; a relatively small population spread across a massive landmass. It’s dealing with the same issues and social pressures. People want to blame someone for inflation and the supermarkets are in the front line. Cost increases and shrinking pack sizes are largely being pushed by the suppliers, with the threat of withholding supply if not accepted. Shoppers don’t like empty shelves.

2. Coles and Woolworths enjoy 67% market share – is that good for competition, is that good for consumers, is that good for shareholders?

It’s really difficult to work out what the real market share is, it depends how you define the market. If you just looked at the pure supermarkets – Coles, Woolworths, IGA and Aldi – maybe Coles and Woolworths add to 67%, but that would be a very narrow definition. There are plenty of other retailers selling parts of their range. Bunnings sells cleaning products and pet food; every pharmacy sells nappies and personal care items and some are very aggressive; Costco sells pretty much everything. Harris Farm sells a wide range of fresh and packaged groceries, and there are plenty of smaller operators out there. Even Amazon is getting in on the grocery act.

The scale of Coles and Woolworths is generally good for consumers as it allows the enormous amount of capital required and substantial operating costs to be shared across a lot of sales. 

You can see what happens a retailer doesn’t have scale: a basket of goods from an independent will generally be way more expensive than from the two majors.

Ultimately, if any business is not working for both consumers and shareholders it will fall apart. 

Either its customers will depart or capital will depart, neither of which is a sustainable position for any company. I think both Coles and Woolworths are aware of that.

3. The Australian Institute
published a paper in February last year, saying that “Food retailing in
Australia is not a competitive well-functioning market” – do you agree
or disagree and why?

Most thinktanks have a barrow to push so I’d be cautious about taking the views of any one of them as gospel. There was a lot of stress placed on supermarkets in recent years and in most cases, the outcomes for consumers have been OK. 

Covid cost both large supermarkets hundreds of millions of dollars in lost sales and additional expenses but they still managed to supply most of what people needed. I think that should be said to be “well-functioning”. 

Reverting to pre-Covid levels of profitability is being portrayed by some as price gouging. 

Inflation is being blamed on the supermarkets yet it is primarily the result of cost pressures in its supplier base, and giving those suppliers more power is unlikely to bring costs down for consumers.

4. What impact is the
recent ACCC action likely to have on Coles and Woolworths in the
short-term, and in the longer-term?

It’s presently unclear what the ACCC might do but it will likely introduce more friction into the system. 

In the short-term, all the publicity might drive some change in shopping behaviour, but only at the margin and only for a period. 

People tend to shop at the most convenient place unless there is a really compelling reason not to, and one thing both have is large networks of stores in convenient places. 

It is unlikely to make a meaningful difference in the long term unless some of the crazier ideas were implemented, like breaking them up. 

The last thing consumers need is less efficiency.

5. If the ACCC is
successful (in ultimately suing for misleading promotional pricing), do
you anticipate there will be further investigations into pricing behaviour
of the supermarkets?

There will be ongoing scrutiny, as there should be. But as long as the ACCC is rational, and the supermarkets act with integrity and have reasonable justifications for what happens on their shelves, they should have nothing to fear. But the ACCC should be looking more widely than just the retailers.

6. Duopolies are not
uncommon in Australia (BHP and Rio, IAG and QBE, Qantas and Virgin). Is
there a realistic opportunity for another significant player to develop in
this market… or is it too small, too concentrated, and the incumbents hold
too much power to expect that will become reality?

We’d be very surprised to see a major new competitor enter this market. Incumbency is a factor but the challenges are far greater than that. 

The last successful entrant was Aldi which has taken 20+ years to get to its current position. Aldi also chose to avoid the more difficult/less profitable markets of NT and Tasmania. Fellow German retailer Kaufland considered coming in a few years ago but baulked when it realised the degree of difficulty and amount of time and capital that would be needed to get to scale.

If there were, say, ten supermarket chains serving Australia, they would probably all need to have prices higher than IGAs in order to survive: that would not be great for consumers. 

Concentration in many industries is a function of having a relatively small population in a very large country: you need scale to create efficiencies – and efficiency is good for consumers – but you can’t get scale if you have a too many players.

7. Ultimately, are Coles
and Woolworths good or bad investments based on how you assess companies?

We’ve found that no company is always a good or bad investment, all companies go through good and bad cycles. We focus on where a company is in its earnings cycle and look to invest in companies with earnings upgrade prospects, avoiding those we can see have downgrades ahead.

We see the near term being a difficult environment for both companies in the wake of the various enquiries and media pile-ons but, over time, both are big companies which provide essential services for all Australians. 

At some point one or both will get through this difficult period, earnings expectations will bottom out and they will have another day in the sun.

8. Do you have a preference
for Coles or Woolworths and, if so, why?

At the moment, Coles has the ascendency over Woolworths, but that story is fairly mature and likely to switch back before too long. 

We’re not particularly enamoured with the space: neither company is particularly cheap and there will be more political and media pile-ons in the near future. 

New management at Woolworths is also an unknown. It will probably be well into next year before we can clearly see a better path ahead. 

Investing in quality, undervalued companies 

Earnings and earnings expectations ultimately drive share prices over time, while valuation keeps us disciplined, and quality factors control risk. To learn more about how Alphinity delivers consistent outperformance over market cycles visit our website or fund profile below.