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.

Woolworths has announced its intention to acquire 80% of MyDeal for $243 million and a substantial takeover premium of 63% compared with its prevailing share price. MyDeal is loss-making and we expect losses to continue over the next 12 months. The rationale for the deal is to build marketplace capabilities. While understandable, this only heightens our concern that Woolworths, Wesfarmers and Amazon will all battle it out over the next three years for the upper-hand online. We are not sure who will win, but we are confident that it will be costly for all involved.

Woolworths 3Q22 sales results show the company is holding onto market share gains in supermarkets and managing COVID-19 costs more tightly. The pace of inflation is picking up across the board, but the drag on volume is small. We expect supermarket sales trends to be consistent in 4Q22e and Big W should return to growth as it laps an easier baseline with less COVID disruptions.

Woolworths reported sales up 8% but EBIT down 11% in 1H22. Even though COVID-19 disruptions added costs, underlying cost growth was also elevated, which we attribute to higher online sales. The company noted that food inflation had accelerated 2%-3% in early 2022, which is a good sign for earnings. We expect Woolworths to proactively work on lowering costs over the next two years.

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.