Who’s winning the food fight

Now that the panic buying has largely disappeared, the action in the aisles at the big two supermarkets is returning to normal

The pandemic has had a major impact on supermarket shopping habits – first in the rush for loo paper and pantry staples in the first lockdown, and then in a tendency for people to stay away from shopping centres and shop more locally. It all meant that the big supermarkets outperformed the independents in the second half of the 2020 financial year before underperforming in every quarter of 2021 (see graph on page 85).

The comparisons in the latest result were toughest for Coles, which had the strongest relative performance in 2020, particularly in the third quarter. In the end, comparable sales fell 6% in its supermarkets business in the March quarter of this year, before recovering 2% in the final quarter.

The performance of Woolworths’ Australian supermarkets business was more muted, reflecting its steadier performance in 2020, with a March quarter fall of 2% and a flat June quarter.

Woolworths has also had a better start to the new financial year, with Australian supermarket sales up 5% in July and August, compared with just 1% for Coles. Consumers are again eating more at home due to lockdowns, although they’re also likely shopping locally, so we’d expect to see the independents doing well again in the current half.

For 2021, Woolworths’ Australian supermarkets business increased sales by 5% to $44.4 billion, and it was able to add 0.2 percentage points to the gross margin (to 29.4%), thanks to reduced stock losses and an improved product mix due to Covid. With costs as a percentage of sales (“cost of doing business” or CODB) remaining flat, that fed through into a 0.2 percentage point increase in the earnings before interest and tax (EBIT) margin, to 5.5%.

Coles’ supermarkets business increased sales by 3% over the year to $33.8 billion and added around 0.3 percentage points to the gross margin (to 25.9%), due to reduced stock losses as well as some benefits from its Smarter Selling program. However, additional marketing meant a 0.2 percentage point rise in the COBD, which pegged the margin gain back to 0.1 percentage points at the EBIT level, to 5%.

Coles’ liquor business increased sales by 7% to $3.5 billion and was able to nudge up its gross margin by 0.2 percentage points to 21.8% due to “strategic sourcing benefits from improved relationships with suppliers”, which we read as “putting the squeeze on and cutting out those suppliers who don’t play ball”.

The relatively fixed cost base meant a 0.3 percentage point fall in the COBD and, in turn, a 0.5 percentage point rise in the EBIT margin.

Woolworths’ drinks business was demerged to form Endeavour Group in June and New Zealand Food’s EBIT fell 5% to $336 million on flat sales due to comparisons with the strict lockdown last year. BIG W’s improvement continued, helped by the consumer focus on homewares, with sales up 12% and EBIT up more than fourfold, to $172 million. However, the current half is expected to be “materially below” last year due to the current lockdowns.

Woolworths has also announced a $2 billion off-market share buyback, at the top end of the range suggested alongside the Endeavour demerger. Shares purchased before September 1 will be eligible to participate and the offer period will run between September 13 and October 15, with proceeds paid out on October 21.

Any shares bought back will have a $4.31 capital component, with the remainder being treated as income and attracting franking credits for those who are eligible for them.

You can offer up your shares to participate in the buyback at a discount of 10%-14%, but it is only likely to make sense for those on low tax rates and doing so through super funds. Woolworths has provided worked examples in the buyback booklet as well as a tax calculator to help people decide. For those with larger holdings, it may be worth seeking advice.

Woolworths’ share price has risen by 12% since the Endeavour demerger, putting it on a multiple of just over 30 times the current year’s expected earnings and taking it past our $40 sell price. Given the solid 2021 performance and the strong start to the current year, we’re happy to raise our price guide back to where it was ahead of the Endeavour demerger – a buy price of $30 and a sell price of $45.

We’re still much closer to selling the stock than to buying it and the buyback offer may provide an opportunity for some shareholders to reduce their holdings in a tax effective manner. Hold.

Coles is up 18% since we reviewed its interim result in February, putting it on a forward multiple of about 23. That’s a significant discount to Woolworths, most of which is deserved, though probably not all. We’re nudging up its price guide to buy below $14 and sell above $22. Hold.

For those with larger holdings, it may be worth seeking advice