Broking Bad: Clean up on Aisle 6 as ASX supermarkets unnerve JP Morgan; excite UBS

Australia’s giant supermarkets - Woolworths and Coles – have been making money but not necessarily friends. JP Morgan sees trouble ahead, but UBS disagrees.

Tim or Tam? By which me mean Woolworths or Coles. Neither, says JP Morgan. Picture: Adam Yip

Welcome to Stockhead’s Broking Bad – Where the analysts go bad, the companies get mad and the shareholders feel sad.

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There’s certainly been some angst around Aussie supermarkets lately.

Cost-of-living pressures across this fine food-lovin’ country remained tight.

Because of that, the government and consumer groups are in a constant state of apoplexy because supermarkets are considered mean, yet demand for stuff … er, groceries and toilet paper and such essential items, hasn’t missed a beat.

Even if those same supermarkets have been happily passing on the hit of toppy inflation and rising costs from suppliers to shoppers.

Hey. Tim Tams are five dollars a pop. That alone is enough to trigger fisticuffs in aisle six.

Financial services big dog UBS doesn’t seem to mind too much, however.

We’ve included its Wednesday Upgrade to Buy from Neutral just because of the fury it might inspire.

At asset management giant JPMorgan, however, the feeling is less than mutual.

JPM brokers are altogether feeling more cautious as the political spotlight of recent times continues to draw unwanted attention for the Big Two.

The duopoly-shaped Aussie supers have attracted no less than three major inquiries into pricing and competition, which JPM notes has pretty much stirred up a negative news spiral. That’s had a direct hit on both Woolworths’ (ASX:WOW) and Coles Group’s (ASX:COL) valuation multiples, although earnings impacts are harder to get a line on.

While the major structural changes many have demanded look pretty unlikely right now, JPMorgan does see a prospect for several smaller but meaningful changes, which its analysts reckon could put a squeeze on gross margins and store growth.

That according to the brokers, is likely to embed earnings risk from FY26.

The more tangible and near-term impact on earnings is due to both companies initiating some genuine investment in value, resulting in a more competitive pricing and promotional environment.

“The noise around this is likely to continue into next year’s federal election – Woolworths and Coles have used their market position to drive gross margins and stabilise EBIT margins, prioritising shareholders at the expense of suppliers and customers,” JP Morgan says.

JPM has been good enough to trace out a forward-looking Supermarkets Potential Slapdown schedule:

1. May 7, 2024 – Senate Inquiry final report
2. June 30 2024 – Food & Grocery Code of Conduct final report due
3. August 2024 – ACCC Supermarket Inquiry interim report
4. September 1, 2024 – Woolworths leadership transition to Amanda Bardwell
5. February 2025 – ACCC Supermarket Inquiry final report
6. May 2025 – Federal election (expected)

It’s a packed regulatory/naughty stick schedule for sure.

The intensity of negative news flow into the Federal election is difficult to predict, according to JPM.

Its analysts’ thinking is that it’s quite de rigueur for all political parties to kick the biggies where possible during a cost-of-living crisis.

However, JPM says the potential exists for a new issue to emerge over the next 12 months, reducing the risk around further de-rating.

Qantas began outperforming after management change and the emergence of supermarket pricing issues in Nov/Dec 2023.

A potential shift in political and media focus could occur at any time.

With WOW and COL’s gross margin expansion “among the best in the world,” it is clear both have benefited from their market position and pricing power.

While delivering on near-term financial targets, JPMorgan believes Woolworths and Coles may have got the stakeholder balance wrong during said cost-of-living crisis, which has impacted value perception and driven a political/regulatory cycle.

“We have begun to see the early stages of this, with gross margin pressure driving earnings downgrades for Woolworths (-2.1 per cent in FY24, -3.8 per cent in FY25 and -6.3 per cent in FY26) and Coles (-1.5 per cent in FY24, -2.7 per cent in FY25 and -6.2 per cent in FY26).”

JPM says the sector has already underperformed significantly – Woolworths and Coles have de-rated heavily over the past 12 months, however much of this was before the supermarket inquiries and potential regulatory impacts were mentioned.

As a result, JPMorgan remains cautious on the sector, and for WOW in particular, given the CEO transition and the potential reset of expectations due to regulatory/political pressure, sales underperformance, and current margin levels.

On the other hand, throwing that caution to the wind is UBS, which this week upgraded COL’s rating to Buy from Neutral.

An effusive UBS reckons Coles Group is “bringing home the bacon” after some cracking third quarter supermarket sales results.

Sales for the quarter were right on UBS forecasts of an impressive 5.1 per cent growth. They were also well above the consensus of 4.5 per cent.

Liquor sales were lower than market expectations but slightly better than the broker’s estimate. No one’s going to go broke selling cheap grog, the broker didn’t say, but probably didn’t need to.

UBS is expecting positive tailwinds for the company, including gross margin improvements post the hullabaloo around last fiscal’s apparent shoplifting plague; cost savings from automated logistics mob Witron, alongside better earnings momentum.

The analysts at UBS raise Coles’ FY24 earnings per share by 6.2 per cent and 8.7 per cent for FY25.

Rating is upgraded to Buy from Neutral on the improved outlook and the potential for a higher valuation.

UBS has also lifted the COL target price to $18.25 from $17.50.

A quick note

As I write, Woolworths says total group sales for the March quarter were at $16.8 billion, slightly ahead of US investment bank Jefferies’ estimates of $16.62 billion, and a 2.8 per cent rise from a year earlier.

Naturally outgoing and literally outgoing CEO Brad Banducci warned shareholders of the outrageous caution being displayed by Aussie consumers and the cost-of-living pressures they drag around with them.

Forget moderating inflation, said the CEO, who can out a fire by setting himself on fire (see recent ABC interview), it’s just nitpicking customers saving pennies which has put a slight drag on sales from WOW’s biggest segment, Australian Food.

Total sales for the company’s Australian food business rose just 1.5 per cent to $12.58 billion for the 13 weeks period ended March 31, compared with a 5.1 per cent at Coles, suggesting, as UBS implied that Woolies’ smaller rival is quietly closing the distance on the nation’s largest supermarket operator.

This content first appeared on stockhead.com.au

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