Woolworths is having a challenging time in its core supermarket business. The recent distribution centre strike will impact sales and earnings in 2Q25e, but should dissipate. More fundamentally, the company’s price investment is unlikely to deliver a decent return and online sales are margin dilutive. Across the industry, the drop in supermarket inflation gives us cause for concern about the industry’s sales and margin outlook over the next two years. While a short-term winner from the strikes, broader industry sales weakness will make it hard for Coles to deliver decent sales growth in 2025.

Woolworths reported better 1Q25 sales trends compared with recent quarters. However, the company has increased its price investment to achieve the better sales result. This price investment is likely to continue and will weigh on profit margins in FY25e with a gradual recovery requiring a cost focus beyond that year in our view. There is a risk that the discounting incites a response. Big W and NZ have had better sales growth in 1Q25 as well, but margin recovery will be years away.

The ACCC’s interim report into Australian supermarkets has not produced any alarming concerns for Coles and Woolworths yet. However, it is too early to draw conclusions either way. The interim report is a very preliminary summary of the issues the ACCC will explore.  The ACCC is yet to process much of its data and there will be further submissions and interrogation over the next two months. We expect the risk to Coles and Woolworths is largely around their ability to expand gross margins to offset cost pressures. Beyond that, we expect the ACCC to conclude that the supermarkets do hold market power but are still largely competitive.

Woolworths reported FY24 EBIT of $3,223 million, up 3% on a reported basis, or 1.1% adjusted for the extra week. Second-half EBIT fell by 1.3%. While Australian Food EBIT was decent, New Zealand Food and Big W had very weak results. Online sales are accelerating for Woolworths, but the overall benefit to earnings seems limited given supermarket store profits declined in 2H24. Woolworths also provided guidance on capex at $2.0-$2.2 billion for FY25e.

Australian supermarket volumes are likely to drop by 2% in FY24e on a per capita basis, which is a continuation of declines seen since March 2022. While higher food prices may explain some of the softness in volumes, other factors are at play including channel leakage, lack of store refurbishments and less new product innovation. We forecast 3.0% comparable sales growth for the supermarket sector in FY25e, but a downside case of 2.3% is possible if volumes continue to decline. A low rate of comp sales growth would be very challenging given comp cost growth is unlikely to fade. Weaker comp sales will put downward pressure on Coles and Woolworths profit margins.

Woolworths 3Q24 sales result was soft across the board. Will trends improve from here? We expect Woolworths relative performance to improve in each of its divisions in 4Q24e albeit the ongoing industry-wide slowdown will result in a very modest uplift. Woolworths weak growth relative to Coles is largely attributable to transitory factors. We expect 4Q24e comp growth of 1.2% for Woolworths and 2.5% for Coles. However, with less than 2% comparable sales growth, Woolworths will need cost savings to maintain earnings.

The Senate Inquiry into Supermarket Prices has escalated into a debate about the merits of return on equity (ROE) as a measure of profitability. We certainly prefer ROE and other returns measures over percentage profit margins. However, in the case of Woolworths, the ROE of 27% (pre sig items) is influenced by historical cost accounting, buybacks and demergers. Care needs to be taken in looking at a single year.

Woolworths 1H24 EBIT growth of 3% revealed a stark contrast amongst its divisions, with Australian Food EBIT up 10%, but NZ earnings down 41% and Big W down 60%. The challenge for the company is that its Australian Food sales are slowing rapidly. We also expect the outsized contribution from eCommerce and Digital & Data to moderate. The concern is lower food inflation crimping Food segment margins and a lower profit margin for Big W. With a change of CEO and weaker food inflation outlook, we expect the earnings outlook on the company to be moderated.

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.