In the battle of the supermarkets, neither of them wins

A few short years ago, every supermarket across Australia faced a strange phenomenon: toilet paper hoarding. Shelves sat empty as the supply chains couldn't satisfy the demand, and while Australians struggled to get ahold of basic necessities, big chains such as Coles and Woolworths benefitted from the surge in demand. The easing of pandemic tailwinds will therefore be a challenge that the supermarket giants may struggle to shake in the coming financial year.

This effect, along with the impacts of inflation and rising interest rates, has challenged both Coles (ASX:COL) and Woolworths (ASX:WOW), with both supermarket giants underperforming by ~4% on the day of their reports.

These results have not surprised Timothy Wood, Co-Portfolio Manager at Investors Mutual All Industrials Share Fund. In his view, although these organisations have strong leadership teams, they may face serious challenges as consumers tighten their belts when faced with higher prices. 

"There's no doubt that labour costs are going to go up in the next year or two given what's happening to inflation. There is a scenario where the supermarkets aren't able to pass on those high costs" said Wood. 

In this wire, Tim discusses the key results from both Woolworths and Coles, and shares some insight into both the companies and the grocery sector in the coming year.

Coles Key Results

• Group EBIT: $1,869 m
• Capital Expenditure: $1,199 m
• NPAT: $1,048 m
• EPS: 78.8 cents
• Total FY22 Dividend: 63.0 cents per share

Woolworths Key Results

• Group EBIT: $2,690m
• Capital Expenditure: $2,407 m
• NPAT: $1,514
• Diluted EPS (cents) – from continuing operations after significant items: $125.7
  
• Total FY22 Dividend: 92.0 cents per share

Note: This interview took place on Thursday 25 August. These stocks are holdings in IML portfolios.

Managed Fund

Investors Mutual All Industrials Share Fund

Australian Shares

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What were the key takeaways from this result? What surprised you?

So in FY22, revenues were still reasonably strong, benefitting from strong COVID-related sales. People that weren't able to go to restaurants or their local cafes have definitely been buying more in the last couple of years from their local supermarkets. 

When I was locked up at home and not able to come into the office, instead of buying a sandwich from a café in the city, I'd buy something from the supermarket that I'd prepare at home. 

So that's been a big driver of supermarket sales recently. One thing that surprised us in the Coles release was that capital expenditure forecasts for some new facilities are going to be significantly higher than we expected. So for example, Coles has signed up with a group called Ocado to help them with online delivery. 

But costs there have gone from a previously forecasted $130-150 million to $330 million. So costs have almost tripled for what we don't think is a significantly better service than they were expecting before. So that I think will disappoint in the market. 

The Woolworths result was also a little bit mixed. In the December half of FY22 Woolworths underperformed the Coles business. They've really come back with a vengeance in their Australian supermarket business in the second half. Revenue and profits were stronger than we were expecting for the June half for Woolworths in Australia. 

The biggest surprise for us though was actually the New Zealand result. New Zealand was really weak in the second half. 

Revenue was okay, but really it was costs that stepped up materially in New Zealand, leading to much weaker profit results than we were expecting. 

What was the market’s reaction to these results? Was this an overreaction, an underreaction, or was it appropriate?

The reaction so far has been that both shares sold down. Coles sold down yesterday on the back of their results, and Woolworths sold off a little bit in sympathy. And today, you know, Woolworths is underperforming, down three or four percent. We think that reaction is expected and, probably appropriate given the updates that we got. 

While the FY22 results were, broadly in line with what people were expecting (outside of the New Zealand result for Woolworths), It was really the outlook statements that they've made that were really telling. I think that's where the market was disappointed. It's clear we are now lapping strong sales from COVID periods. 

Fingers crossed that in FY 23 we don't have any more big COVID outbreaks that cause mass lockdowns and big work-from-home events, however, because the supermarkets were benefiting from that in FY22, FY23 will be a tougher period. And so we think the share price falling a couple of percentage points is probably the right reaction to those outlook statements. 

Would you buy, hold or sell Coles and Woolworths on the back of these results?

Coles: Hold

Woolworths: Hold

Yeah look, we have been reducing our holdings in both companies until recently. Supermarket share prices have been really strong in the last 12 months or so, and we have been reducing our holdings into that strength. I think with the new information that we've learned from the results, we're probably not likely to reduce further, as we have very modest supermarket positions now. 

We'll probably hold onto our existing positions, but we also think it's too early to be buying yet. I think the market's got a lot to digest from these results. I think we really need to see the impacts of inflation, higher fuel prices, higher energy prices, and higher mortgage repayments before we can really get a sense of how the companies are going to perform in the next six to twelve months. That's really the million-dollar question. 

Looking beyond Coles and Woolworths, our pick in the supermarket space at the moment is actually Metcash. The business is still doing really well, with a significantly cheaper valuation. We also like the new management team, and so that's where we have an overweight in the sector at this stage. 

What’s your outlook on Coles, Woolworths, and the groceries sector over FY23?

So in general the supermarkets have benefited from COVID lockdowns, with people eating out less and shopping at supermarkets more. With that in mind, we think that the revenue environment going forward's going to be tougher than it's been for the last couple of years. 

Woolworths also just reminded people that versus three years ago, supermarket sales have grown 5% per annum (in the first 7 weeks of FY23). Supermarkets are still growing the number of stores that they have, and population growth, driven by immigration, is starting to pick back up again, so they'll benefit from that. 

I think the big question for the FY23 outlook is what's going to happen with costs, and also how the consumer is going to react. Are consumers still going to buy exactly the same things that they were buying before, and be happy to be spending five to ten percent more on their groceries? 

I think we'll see customers trading down; instead of buying a steak or fish for dinner tonight, maybe they'll buy chicken or pasta instead. 

Those are the sorts of decisions that we need to see happen across the whole country before we really get a feel for what revenue is going to be like. 

We do like the supermarket space as compared to many industries, they generally have quite predictable revenues and profits. Coles and Woolies both have good balance sheets, they've got good management teams, and they pay healthy dividends. So it's still an attractive sector to us, it's just not one that we'd be adding to at the moment given the current outlook and valuations. 

Are there any risks to Coles, Woolworths, and the supermarket sector that investors should be aware of given the current market environment?

The big risk to the sector at the moment is what happens with the consumer and the inflation pressures that are in the system. Those are going to be really important to see how the supermarket stocks play out. 

Take the New Zealand example for Woolworths where costs went up dramatically in the second half and they clearly weren't able to pass it on in the revenue line. There are scenarios that we think about where maybe profit margins do come down for supermarkets because they can't recoup higher labour, energy, and transport costs. 

There's no doubt that labour costs are going to go up in the next year or two given what's happening to inflation. There is a scenario where the supermarkets aren't able to pass on those high costs. And so, therefore, their profits would be impacted.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

I'd say at the moment we're at about a four, so slightly expensive. I think we are coming back towards a three, but it really is dependent on the sector that you're looking at. We do think the markets are modestly overvalued at this price, and so we are cautious on several sectors. 

That being said, this is the time for active stock pickers like ourselves, there is value in particular parts of the market, and so it's up to us to do the work in order to understand where that is. 

A major reason that we are cautious is that commodity prices are really high. The Australian share market is heavily exposed to iron ore, coal, oil, and natural gas, so those commodity prices could fall back. We are also cautious because valuations, in general, are still more elevated than we would hope to see. 

In terms of value, we quite like the insurance space at the moment with IAG, Suncorp, and Steadfast. We've been adding to those recently, as that's a sector that's demonstrated that it's able to pass on the higher claims costs.

The other sector that we've been adding to, and still see value is in the media space. Nine Entertainment came out with a good result today. It's no longer an old-world media company and has strong digital assets which allow consumers to watch TV and movies on demand, such as the Stan video platform. 

They also have a big shareholding in Domain and overall there are really good things happening in that business, as we've seen in the result today. Advertisers are still spending money on advertising and this benefits many of the Nine Entertainment businesses. 

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