Grocer Disruption

Should you invest in Australia’s grocery market?

The Grocery business in Australia has been a consumer staple investment choice for many decades with reliable, steadily growing dividends from a growing population and inflating food prices. However, the imminent arrival of Amazon and rapid growth of foreign retailers like Aldi, Costco and Kaufland has put the fox in the henhouse.

In the United States, 52% of households have an Amazon Prime account – that’s more than the number of households that own a gun or have a landline there. So, the Australian retail market is understandably concerned.

US fashion brands are already beginning to feel the pinch as consumers move towards online retailing. Bebe recently closed all 180 of its stores there and may file for bankruptcy to get out of its store leases, selling only online thereafter. Meanwhile 44-store fashion chain Neiman Marcus/ Bergdorf Goodman announced it won’t pay interest on a $600 million bond issue in cash, but pay instead in ‘kind’.

In Australia, struggling retailers include David Lawrence, Marcs, Payless Shoes, Pumpkin Patch, Herringbone and more recently joined by Top Shop.

The implications of Amazon on our Australian equity market will be material, but possibly not in the ways anticipated. Amazon’s retail share in the US by category gives some insight as to where its impact may be most felt here. It has 5% of non-food retail spend in total and 8% of apparel spend, but only 1% in each of consumer electronics and grocery. Woolworths and Coles may be affected but their prices are already competitive for the most part. Most commercial vulnerability may be felt by those with business models reliant upon apparel and also with long dated, expensive leases.

Indeed, Amazon’s recent acquisition of Wholefoods Markets in the US shows the importance of having a grocery solution with physical retail locations. That Wholefood Market purchase gives Amazon 456 stores (and 98 being developed) across the US, Canada and UK, as well as distribution networks to support them.

Australia has three main ASX-listed grocery stocks – Woolworths (WOW), Wesfarmers (WES) and Metcash (MTS).

Wesfarmers generated 5.9% total return over the past 10 years including the GFC. Its diverse operations in many Australian business sectors cover supermarkets, department stores, home improvement and office supplies (Coles, Target, Kmart, Officeworks and Bunnings). These generate 90% of its revenue – the rest comes from resources, chemicals, energy and fertilisers, and industrials and safety products.

Woolworths is Australia’s largest supermarket company but generated just 1.3% total return over the last 10 years, recovering last year to edge out Wesfarmers over the last 12 months. After Wesfarmers acquired and began reviving Coles, Woolworths stumbled with its ill-considered venture into hardware. But Woolworths also has diverse business, mostly in supermarkets here and in NZ, augmented by BIGW discount department stores, home improvement, hotels and petrol through its Woolworths/Caltex alliance. Like Coles, Woolworths has the best located shops and this offers some advantage in the growing price war with new international entrants, Aldi, Costco, Kaufland and Amazon Fresh. Woolworths also had the highest profit margins, now being whittled back in the grocery price war over the years ahead.

Metcash is smaller and less diverse – the dominant wholesale distributor and marketer for independent grocers in Australia, producing a 10 year return to shareholders of -0.7%, though surging back in the last year to return 34.9%. Metcash specialises in grocery, fresh food, liquor, hardware and automotive parts & accessories with a smaller liquor business in New Zealand. Unfortunately, Woolworths, Coles and Aldi are using their larger buying power to increase their supermarket share at the expense of independent retailers. Metcash and its independents do have the advantage of ‘convenience’, though shoppers seem willing to sacrifice this for lower price. Metcash’s $2 billion of hardware revenue from Home Timber & Hardware is mostly from tradesfolk, where strong independent relationships can compete with Bunnings (Wesfarmers).

Overall, Australia’s grocery market is becoming more price-competitive as Aldi, Costco then Amazon and Kaufland establish themselves. All are highly efficient with compelling customer value that makes it challenging for our major supermarket chains to compete. The high profit margins Woolworths, Coles (and Metcash) commanded from their almost duopoly is not possible elsewhere in the world and this is now coming to an end. Even so, Woolworths and Coles have well-located shops and reasonable value, so market share being acquired by new international entrants, has been coming from independents. While better independents can fight this off with high quality shops, the ‘also ran’ independents lose in this price war.

What’s an investor to do?
Which of Woolworths, Wesfarmers and Metcash has the most potential, or should you sit this one out? Might you just buy less than your usual full weighting in these stocks now, then add at low spots as the grocery price wars evolve?

We think an investment in either Wesfarmers or Woolworths continues to have merit, despite the challenges. Wesfarmers has scale and cost advantages and though it is still digesting its 2007 Coles acquisition, return on its invested capital comfortably exceeds that capital cost. Sales from Target, Kmart and Officeworks may be at risk from Amazon as their products are easily sold on-line, but hugely successful Bunnings remains reasonably safe from Amazon and other competitors for now.

Woolworths is doing well on-line and has gained in overall food sales at the expense of Coles, so it seems to have the edge in this duopoly for now. But BigW is dragging on Woolworths’ current rise, so that edge may not last. Having less discretionary retail than Wesfarmers may shelter Woolworths a little from the coming Amazon storm.

So, what about Metcash? International competition could either kill it, or present an opportunity for a large contract or even takeover, from one of them seeking to utilise Metcash’s distribution network. So here, it may be all about timing and share price. Buy and hold seems less appealing.

If you would like to discuss the information in this article or your investment options with one of our wealth management professionals, get in touch today!


Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.