Woolworths’ trading update provided comfort that its core business in Australian Food is doing well, but Big W and NZ both have significant challenges that will take years and money to fix. Big W may close stores and NZ is more than three years away from decent margins in our view. The industry backdrop of government scrutiny and fading food inflation will mitigate expectations.

The Australian supermarket sector is under scrutiny given higher grocery prices. This report is written to give perspective about prices, profit margins and potential risk areas as the Senate inquiry is held over the next four months. Price increases in supermarkets largely reflect higher costs. However, retail prices have risen faster than the producer prices in fresh produce and red meat. Like almost all Australian businesses, supermarkets have faced higher costs and their profit margins are only slightly higher than pre COVID-19 levels.

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.

Metcash’s reported 1H23 sales growth of 8% and EBIT growth of 10%. Price inflation drove more than half the sales growth and will remain a key driver over the next 12 months. There will be some normalisation in Hardware sales, but its mix of business supports margins. The Food business will benefit from stock profits and is holding market share. While 1H23 had weak cash flow, the result will mostly normalise in 2H23e and a higher working capital position is the reality of having more hardware and less tobacco sales.

Woolworths reported 1Q23 sales growth of 1.8%. This low rate of growth simply reflects a high hurdle from lockdowns over the past two years. We expect sales growth to recover to 5%-6% from here and the growth gap to Coles will narrow. The market remains orderly around price inflation, which will support earnings growth. Moreover, the headwinds in NZ should ease soon and margins are likely to recover in calendar 2023.

Coles Group reported 1Q23 sales growth of 1.3%. This is a low rate of growth, but an aberration compared with likely growth over the remainder of FY23e. The first quarter was lapping lockdowns. We expect Coles Supermarket comp sales growth to recover to 5.9% in 2Q23e and Liquor should recover to be almost flat. All of the sales growth over coming quarters will be price inflation with some modest volume declines.

Consumer sentiment for October 2022 is 19% below the long-term average, suggesting consumers are worried. However, consumer sentiment is at odds with consumer spending. Most of the time what consumers say and what they do disconnect. Instead, we focus on measures of consumer behaviours in order to gauge the retail outlook. Restaurant and café spend has a 3x stronger correlation with retail spending than consumer sentiment. Restaurant bookings are up 23% on pre COVID-19 levels in October. Housing churn is up 80% on pre COVID-19 levels. Food inflation is 14% higher than 2019 and retail spending is up 25% on 2019 levels. There are no signs of a slowdown in spending behaviours on the near-term horizon.

Measures of consumer behaviour and sentiment

The outlook for Coles and Woolworths in 2022 is looking better. The risks around COVID-19 costs are now well managed. We expect upside from consumer stockpiling near-term will lift sales earnings and higher food inflation over the next 12 months will be positive for earnings. In this report we look at how the COVID-19 costs may unwind and the impact that higher food inflation will have on the supermarket sector.

Metcash has stabilised its food market share over the past two years and Hardware sales and earnings are likely to grow meaningfully. Metcash is perceived as a COVID-19 beneficiary and therefore has struggled to re-rate in recent months. However, our analysis suggests that its market share in Supermarkets is likely stabilised for more fundamental reasons. Competitors are opening fewer stores, IGAs are no longer shutting stores and the risk of contract losses is now in the rear vision mirror. In the hardware industry, Metcash is likely to gain share given its 60% skew to trade and continued rollout of Total Tools stores.

Coles (28 October 2021) and Woolworths (27 October 2021) will release 1Q22e sales next week. We forecast Coles to deliver 0.9% comparable sales growth in Supermarkets, with Woolworths at 3.3%. The gap will have opened in Woolworths favour given lockdowns favoured online sales and Coles had availability challenges given disruptions from COVID-19 in its DCs. We expect these issues are likely to unwind and the growth gap will narrow considerably beyond 1Q22e.