Supermarkets – no longer a defensive safe haven for investors

Previously loved for slow, but steady growth and hefty dividends, the supermarket sector is no longer Australia’s safe haven. The industry has fallen under pressure as discounter Aldi disrupts the age-old battle for market share between retail giants Coles and Woolworths. While Aldi is posing some significant growth challenges for the sector, there are some retailers who may have some immunity to the discounter effect.

Why Aldi is unstoppable – and what matters

Overall, supermarket sales are slowing, partly driven by falling innovation in supermarket products available for sale, and partly driven by the presence of more competitors and stores in the market, which creates industry deflation as competition increases.

Supermarket sales growth year on year

Sondal1

Source: Company Data, ABS

Aldi’s low pricing strategy, combined with an outside-the-box product range, has rapidly snapped up consumers.

Market share is shifting from the majors to the discounters

Sondal2

Source: Company Data, ABS

This ultimately forces incumbents to spend more money on store expansion, differentiation and customer experience to maintain their growth – while at the same time they are forced to reduce their profit margins.

Since the GFC we have seen significant acceleration in industry space growth as Costco and Aldi gain foothold in the market. Woolworths has invested heavily in new store rollout to increase its accessibility, even at the expense of cannibalising its own sales.

I’ve written before that Aldi will be a difficult competitor to stop as they reach scale. During my research trip to Europe, I observed supermarkets need around 300-350 stores to reach a point of scale, after which they can more aggressively move into the next growth phase.

Aldi has achieved scale across the east coast of Australia and with it has taken a proportionate share of the market. The retailer has plans to achieve a similar scale in the South Australian and Western Australian market in the coming months.

Looking at the lifecycle for a discounter below, Aldi has already hit a number of significant growth phase milestones:

  1. Low prices on private label
  2. Introduce some brands at zero profit margin to gain traction
  3. Introduce a narrow range of fresh products at zero margin
  4. National advertising campaigns to grow market share

The biggest problems with these for the incumbents are the introduction of fresh products and branded goods at zero profit margins – Aldi is seen as cheaper while retaining a perception of good quality. Choice put the prices of the major retailers to the test and found Aldi up to 27% cheaper than its competitors. Their June 2015 Consumer Survey found that the cost of private label goods (excluding specials) as follows; Aldi ($87.68), Coles ($114.24), Woolworths ($119.40).

How can the retailers respond? Globally, only France has beaten the entry of a discounter to the market, but this came with significant margin pain for the industry. In Australia, the incumbents are already slashing prices on private label products, further consolidating stock in an attempt to reduce inventory costs (although interestingly, offering a broad range was formerly considered a competitive advantage). The result is that EBIT margins have likely peaked for 2015.

But that’s not to say there aren’t opportunities in the supermarkets space. We are looking for companies with low dependency on profits from private label and fresh produce.

 

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