The outlook for the nation's biggest supermarkets Coles and Woolworths could be looking up after German hypermarket Kaufland scrapped plans to open 20 supermarkets across Australia.

Morningstar equity analyst Johannes Faul, who has written extensively on Kaufland's first foray outside Europe, said its decision to exit the Australian market eliminates a mid-term risk for incumbent grocers Woolworths (WOW), Coles (COL) and wholesale distribution company Metcash (MTS).

"Kaufland’s decision to exit Australia is undeniably a positive for competitors Woolworths, Coles and Metcash," Faul said in a research note.

In a November special report, Faul says competition from cut-price German grocer Aldi as well as the online might of Amazon was forcing Australia's supermarket giants to slash prices, impeding any meaningful margin improvement.

Kaufland was anticipated to compete with major supermarket chains in groceries, but also with Woolworth's Big W discount department store in the general merchandise category.

Kaufland announced its decision to shelve its Australian launch yesterday, sending shockwaves through the retail industry.

Management cited better expected returns in European markets as the chief reason for its change of heart.

“This was not an easy decision for us. We always felt welcome in Australia. We would like to thank our employees and we apologise for the disruption this decision will cause," Kaufland International acting chief executive Frank Schumann said.

“In Europe, we see a great deal of growth potential. We will actively shape the consolidation of the European retail sector, thus further reinforcing our leading position.”

Faul said the decision took analysts by surprise, particularly as Kaufland had already acquired store sites, hired some 200 employees, and begun work on a distribution centre.

"We had expected Kaufland to open its first stores before Christmas 2020, competing with both the major supermarket chains and discount department stores Big W, Kmart, and Target in general merchandise," he said.

Kaufland is operated by the privately-family owned Schwarz Gruppe, which is the world’s fourth largest retailer by revenue. It also owns discount store Lidl.

woolworths metro

The announcement sparked a surge in listed rivals Woolworths up 3.3 per cent to $41.32 and Coles up 3.0 per cent to $16.62. Consumer staples stocks were the biggest performers on yesterday's share market, which smashed through the 7100 mark.

Materially overvalued

While Faul had been a keen observer of Kaufland's ambitious plans, its impact had been excluded from his sector forecasts given the uncertainty and long timeline of their entry and establishment of market share.

"Kaufland’s store network would have likely taken decades to roll out, like Aldi’s, and the hyperstore format’s appeal to the Australian consumer was never a given," he says.

As such, he has maintained the fair values across Coles, Woolworths and Metcash, and continues to forecast relatively flat earnings margins for Australian supermarkets.

At the current share price, Metcash screens as slightly expensive and both Woolworths and Coles shares screen as materially overvalued.

"We maintain our fair value estimates for narrow moat Woolworths at $27.50, no-moat Coles at $12.50 and no-moat Metcash at $2.30," he says.

Kaufland first announced in arrival in Australia in 2017 when it snapped up a site in South Australia for its first major supermarket.

Since then, it gained approval for a super-sized distribution centre in Melbourne's northern industrial suburbs, investing $459 million in the process, and picked up big names in retail including former Myer chief executive Richard Umbers and former Metcash and Woolworths executive Mark Hewlett as chief operating officer.

Its first stores were set to open in Victoria before expanding into South Australia and NSW.

Amazon on the horizon

Kaufland was not the only foreign raider looking to Australia for growth. Amazon Australia already sells pantry items in the Australian market, and Faul anticipates the launch of Amazon Fresh, Amazon's grocery delivery service, in coming years.

Nonetheless, he says Amazon's entry is unlikely to "materially affect the majors' earnings growth in the foreseeable future".

"Woolworths’ and Coles' online market shares and mature relationships with Australian suppliers take years to replicate. Aldi took nearly two decades to reach its current 8 per cent market share."