We expect a strong year of earnings growth for Australian supermarkets in FY23e. Higher food inflation is boosting sales and gross margins are also rising. We lift our FY23e EPS forecast for the major chains. Woolworths has the strongest sales growth, followed by Metcash, then Coles based on our feedback. In the full report, we address the cycle of price inflation and outlook over the next 12 months; and the outlook for Coles and Woolworths gross profit margins and EBIT margins.

While retailers and manufacturers have grappled with a range of cost pressures already, wage cost pressures are only starting to build now. In Issue 3 of Price Watch, we analyse the size and scope of likely wage pressure facing companies. As most retailers are inextricably linked to broader wage-setting mechanisms, we may see an additional 2%-3% higher annual wage inflation over the next two years. The companies with the highest sensitivity to wage inflation are Inghams, Costa Group, Coles and Woolworths.

Coles had stronger 3Q22 sales growth largely driven by higher food inflation. While market views vary, it is clear that inflation is adding to revenue growth with more to come over the remainder of 2022. Even with better sales growth, Coles is losing share, driven by fewer store openings. The company may be rational in shutting stores, but the rest of the market is not following. Coles Liquor comparable sales growth was a highlight, comfortably outstripping Endeavour. However, the business has a long way to go to lift sales productivity to a level anywhere near Endeavour.

Coles reported 1H22 EBIT down 4% to $975 million. The company has managed costs well and stabilised market share in Supermarkets, while growing share in Liquor.  We expect sales and earnings to improve in 2H22e, driven by higher food inflation. We estimate an acceleration of 150bp in packaged grocery inflation. Note there will still be a headwind to earnings in Liquor from rising costs and in Express as tobacco sales fall.

Coles reported FY21 EBIT of $1,873 million, up 6%. The second-half EBIT was flat. Coles Supermarkets had a much stronger 4Q21 sales result and stabilised market share. While the sales outlook is improving, we note that cost growth was elevated in FY21, and higher costs will be a handbrake on any further margin expansion.

We have a positive outlook for both revenue growth and profit margins for Coles, Metcash and Woolworths. Higher food inflation is likely to show through and offset the pressures from lower population growth and lapping COVID-19 induced sales growth. Higher inflation is not simply transitory, but has been evident since 2019. The market structure in both supermarkets and liquor add to the investment appeal. We also see a strong recovery for Endeavour Group and can make acquisitions in Hotels.