Supermarket headwinds prompt fair value cut for majors

Glenn Freeman | 06/12/2016

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Glenn Freeman: I'm Glenn Freeman from Morningstar, and I'm joined today by our equity analyst, Johannes Faul.

Johannes, thanks for joining us.

Johannes Faul: Thanks for having me, Glenn.

Freeman: Johannes, just last week Morningstar issued a special report downgrading the fair value of Coles and Woolworths. Can you just talk us through this?

Faul: Morningstar conducted an in-depth research on the grocery market in Australia. So, what we've done is, we looked at the key drivers for the industry, which is, top-line revenue and also the EBIT margins, so how much of that top-line revenue actually drops down into profits. And we adjusted our assumptions and our estimates on that.

I guess the key change really is in our outlook, what we think, what the competitive environment is going to be going forward and what those competitive forces are going to do to our EBIT margins for the stocks we cover, in particular, Woolworths, Wesfarmers and then Metcash as the wholesaler.

And what has changed our view is previously, we thought that Woolworths management would turn around the business in a sense that it would also expand its margins, against its EBIT margins.

However, now we take the view that it will successfully defend its current market share at around current levels and maintain that in the long term, but that EBIT margins will remain just below current levels.

The reason for that is that we think in the competitive environment that we're seeing in that we expect to continue for number of years at least that in this environment it's unlikely for one of the competitors to expand their margins basically to expand their profits above that their competitors are receiving.

Freeman: Now, both Coles and Woolworths hold narrow economic moats. Does this change impact those at all?

Faul: That's absolutely right. So, Woolworths and Wesfarmers both have a narrow moat Morningstar rating, which means that we believe that they will be relatively sheltered, in a sense, from competitive pressures going forward.

When we talk about these competitive pressures, we are thinking about fully integrated supermarkets. So, the way we think about the Australian grocery industry is we segment it into different segments.

So, first, in the middle we have the fully integrated supermarkets which are Woolworths and Coles and now through Aldi entering the market they basically carved out the discounting channel which hadn't really existed for a number of years in Australia and we also believe that Aldi will keep that market share.

However, within the space, which Woolworths and also Coles are going to be operating over the next few decades, we believe that the vast store network and also the locations of the stores that they do have give them a competitive advantage over any new entrant that will want to compete directly on their, let's say, more than 25,000 SKUs or stock keeping units that they offer directly.

Having said that, both those narrow moats are in a negative watch or on a negative trend as we call it at Morningstar which basically means that we are closely monitoring that narrow moat and the competitive pressures at the moment do threaten that narrow moat to a degree.

Freeman: And Johannes, what has prompted this change now and not say, six months earlier?

Faul: Basically, what we've been seeing in this supermarkets industry is very intense competition and that has heated up quite dramatically over the last couple of years. Also, what we've been seeing and what is likely to continue is price deflation. So, your average SKUs are actually getting cheaper in real terms.

And as we said, this has been ongoing for a while and we've already seen that six months ago.

However, at Morningstar, we generally take a very long-term view on our markets and on our views of the market and where it's trending. And in doing so, the near-term margins we already had lowered for both Wesfarmers and Woolworths; however, it's the long-term outlook really that we've changed, amended and that has had that significant impact on our valuations.

So, our long-term outlook now has changed. We're no longer indicating a turnaround or an increase of margins, but more or less keeping at current levels, maybe a bit of downside in our view.

And the reason why we're doing this now and not six months ago is just the evidence that we've been seeing over the last six months has all fed into this analysis that we've conducted. And now we think we can with higher degree of conviction really say there's more risk on the downside where margins keep remaining than basically margins expanding again.

Freeman: And just lastly, you've mentioned the competitive pressures. How credible is this threat posed by players like Amazon and some of the others in that space?

Faul: Yeah, that's another very interesting point. So, we've seen the impact that Aldi has had and the popularity it's actually had in Australia and the growth it has experienced and we believe that Aldi is going to continue growing faster than the market over the next four years.

And then obviously immediately brings to mind other competitors that might enter Australia and successfully compete and take market share from Coles or Woolworths or IGAs and even intensify the competition even more so going forward.
So, some of the names that are out there that have been discussed in the media quite frequently are Amazon on the online segment or business. So, they are offering Amazon Fresh in the U. and also in the UK.

However, for Amazon, we really think for them to succeed, firstly, it's going to take a very long period of time for them to implement their business and build it in Australia.

So, in the US they entered in 2008 and eight years later we believe they have roughly only 1 per cent of food retail market in the US, so not online but of the entire food retail market, we believe Amazon only has 1 per cent market share eight years later. So, again, we think that it's a credible threat, but we don't think it's an imminent threat or a material threat to near-term earnings.

Then another competitor talked about a lot in the press recently is Lidl. So, Lidl already competes with Aldi in numerous European markets and is now entering the US.

Currently, they are building distribution centers on the east coast in the US and also will roll out their stores following that.

So, given that they are entering large new markets as we speak, we believe that that's where the focus is going to be on at the moment as a group and we think it's unlikely that they'll forge ahead with the new venture here in Australia imminently or anytime soon.

Also, when Lidl does eventually enter, we believe the main competitive pressure there will be felt by Aldi within the discounting channel or segment. So, again, we differentiate here between different channels. So, yes, there is more competition looming on the horizon, but if it happens, it will be a long-term thematic.

Freeman: Thanks for your time today.

Faul: Thank you so much, Glenn.

Freeman: I'm Glenn Freeman from Morningstar. Thanks for watching.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

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