Aldi a much bigger threat to supermarkets than Amazon

Online giant Amazon hogs the headlines but the German supermarket chain Aldi is drawing the Australian customers.

The rise of Aldi is unlikely to slow any time soon because of its ­aggressive rollout plan.

Retail investors are focusing hard on the future of Coles versus Woolworths.

The main loser to date from Aldi’s rise has been Woolworths as Coles is more or less maintaining its market share after gaining ground between 2009 and 2015.

The reason for Coles’s success during this period is twofold.

First, under new ownership, the company spent a lot of money on store revamps to make its ­offerings more appealing.

In ­recent years it has spent a significant amount of growth capex to catch Woolworths. The chart below compares their capex spend to their depreciation charge (a proxy for sustaining capex) to show how ­aggressive the spend has been.

With more appealing stores, Coles closed the quality gap ­between itself and Woolworths.

The second aspect of its success was undercutting Woolworths on price.

Coles typically ran earnings before interest and tax margins of less than 5 per cent versus Woolworths’ 6 per cent-plus. Consumers ­started to ­migrate to the cheaper option.

Woolworths’ margins (which were the highest of any super­market in the world) were simply unsustainable. The company has now realised this and has started to compete with Coles on price, as can be seen by the fall in margins below.

The problem for Woolworths and Coles is that they are probably fighting for a smaller pool. The rise of Aldi is unlikely to slow any time soon because of its ­aggressive rollout plan.

Aldi continues to have significantly lower margins with lower grocery prices and smaller store areas (meaning lower overhead costs such as rent).

EBIT margins for Aldi in Australia were 4 per cent last year, ­according to the Australian Taxation Office.

Another competitor set to gain market share is Costco, whose unique business sees it run EBIT margins of less than 3 per cent.

­Costco makes over three quarters of its profit from membership fees (now $55 a year in Australia) so can sell goods to consumers near cost, hence the name.

The Amazon decoy

Then there is the imminent ­arrival of Amazon in Australia.

This is less of a worry than the above threats. Amazon has struggled to make meaningful headway in the US as consumers still prefer physical stores for groceries. Its market share stands at about 1 per cent in the US and, in an attempt to grow, the company is experimenting with bricks-and-mortar outlets in Seattle.

While Amazon is grabbing headlines, the biggest threat for the major supermarkets remains Aldi. The constant of an aggressive low-cost competitor means life will remain difficult.

Despite that, we have seen a solid rally in Woolies’ share price since June. The rerating has been driven by two consecutive quarters of solid sales growth and a rerating in the price to earnings ratio from about 16x to 23x.

Meanwhile, Wesfarmers, the parent company of Coles, has gone the other way and seen its P/E ratio fall from more than 20x to 16x (driven by a flat share price and rising earnings from its coal division).

The rerating of Woolworths’ price-to-book valuation multiple has been on a similar scale, going from about 3x to 4.1x — a level similar to what the company traded on between 2009 and 2014.

This is despite return on equity (which is the return on the book value that should justify the above multiple) having fallen significantly in recent years.

From the above valuation metrics, it appears the popular trade is to bet on a Woolworths turnaround. But if we were running an index aware strategy, we would much prefer to take the 16x on Wesfarmers rather than pay 23x for Woolworths.

In addition to a cheaper valuation, Wesfarmers has the added advantage of owning Bunnings, a high-quality business that represents 34 per cent of Wesfarmers’ EBIT. It is now growing at a ­double-digit rate and has a return on capital employed of more than 35 per cent.

While we would be more likely to invest in Wesfarmers than Woolworths at present, we don’t because of concerns that the market is underestimating the continuing growth of Aldi on both businesses.

It’s an odd thing, but if you were to travel back in time five or 10 years and asked Australian fund managers to name some of the highest quality companies listed on the ASX, there would be a very good chance that several of them would name Woolworths.

For a long time the company was so consistent with its store rollout, earnings growth and ­returns on capital that it was hard to go wrong buying its shares. ­Unfortunately that has changed.

Guy Carson is head of Australian value strategies at TAMIM Asset Management.

www.tamim.com.au