Woolworths hosted a tour of its Melbourne South Regional Distribution Centre (MSRDC). This highly automated DC opened 2019 but COVID-19 delayed any inspection of the site. Woolworths spent over $560 million, including capitalised lease costs, and we estimate the return on investment at 7%-9%. While Woolworths has a different partner to Coles, we expect a similar outcome in terms of cost per case in the automated DC and a similar return on investment. The shift to automation comes at an important time for the supermarkets given escalating wage cost growth. While these DCs are impressive, they are more likely to offset to wage pressures than lift profit margins.

Tobacco may be somewhat inconspicuous in supermarkets but it has a meaningful impact on sales and margin outcomes given demand has dropped significantly in the past year. Metcash faces the biggest headwind given tobacco could account for 15% of group sales. The drop in tobacco is partly driven by the rise of illicit tobacco and vaping.

The Fair Work Commission’s decision to increase wages for FY24e by 5.75% will create a headwind for retailers. The magnitude of the pressure will depend on the sales run-rate and given we are already in decline in non-food categories, the squeeze from rising costs and falling sales could lower earnings in FY24e by 8%-14% for many non-food retailers. Our review of consensus expectations suggests the market is too low on cost growth for Bunnings, Super Retail Group and Premier Investments. We also note that the Fair Work Commission suggested that future pay rises are more likely to be above inflation, which adds to risks in FY25e.

Woolworths reported an impressive 6.6% comparable sales growth in Australian Food in 3Q23. While Woolworths sales growth is good there are some challenges. Its superior growth is more a function of eCommerce and new stores, which has additional costs. Moreover, growth rates are likely to slow as food inflation fades over the next 12 months. We expect good earnings growth in FY23e, but growth is likely to slow next year.

A successful retailer has the right product, at the right price, at the right time. However, retailers regularly find themselves with the wrong inventory position. In Issue 6 of The Retail Mosaic, we assess the metrics used to measure inventory, the most useful red flags and the margin pain a retail with too much inventory may endure. A retailer with excess inventory can quickly sink into financial losses, but the impact usually lasts no more than 12 months. While some Australian retailers have excess inventory, the problems are being cleared quickly and inventory positions are likely to be more balanced in 2024.

The debate about Australian wage rates is about to flare up as submissions are made for the FY24e minimum wage determination. We think a result anywhere from 4%-8% wage rate growth is possible. At 4%, retailers are likely to manage decent margin outcomes given some variability in staff costs. At 8%, the impact on retailer EBIT could be a hit of 5%-15%. For consumer goods producers the earnings impact could be -20%. The retailers most vulnerable are Domino’s and the supermarkets, Coles, Metcash and Woolworths. Costa and Inghams have high fixed wage costs and could be hit too, but the impact may be smoothed over two years given enterprise agreements.

Woolworths reported a strong improvement in profit margins in 1H23 driven by its Australian Food segment. COVID-19 costs have unwound and cost efficiency programs are delivering results. We expect further margin gains in 2H23e, albeit at a smaller rate. The challenge for Woolworths is its profit margins will be close to long-term averages by the end of FY23e and EPS growth may step down to single-digits in FY24e and beyond.

Australian retailers will deliver good results for the upcoming reporting season in February and March 2023, once again mystifying many that worry about higher interest rates. While reporting season will reveal impressive earnings for most, we are becoming more cautious. It may sound like a contradiction, but this set of results is likely a peak and earnings could fall meaningfully over the next 18 months as sales growth falls below cost growth.

We expect Christmas retail sales to surprise on the upside with a partial offset in lower profit margins. The strongest feedback comes from department stores, electronics and supermarkets. However, not all have done well. Off-premise liquor looks to be in decline and womenswear feedback is weak.

Woolworths has announced a majority stake in Petspiration Group for $586 million, at an EV/EBITDA of 11x. This is a full price, particularly given Woolworths will deliver the majority of the synergies. We are concerned that industry-wide revenue may recede given the COVID-19 pet boom added more than 2.5m dogs and cats to households. Woolworths is building out its “ecosystem” and Petspiration is a natural extension. However, the more important share price driver is Australian Food, which needs to demonstrate that previous capex is delivering a return on investment.