Supermarket shares investors pay the price

It is challenging to see how either Coles’ or Woolworths’ share prices could rise.

Supermarket price gouging is a burning issue; I covered it here only a fortnight ago. Since then, the pressure on supermarkets is clearly mounting.

Most recently, Woolworths boss Brad Banducci shocked the market by stepping down less than 48 hours after an ABC Four Corners story about supermarkets abusing their duopoly power.

Perhaps most interesting is the increasing boldness of suppliers and current and former staff in coming forward to reveal practices that are at times nothing short of shocking.

As an aside, investors make money when companies grow their profits – preferably by raising margins – and/or the price-earnings ratio that people are willing to pay for those earnings rises.

Woolworths shares are currently around $33 on a (trailing 12 month) P/E of about 25 times, while Coles is around $15.50 on a P/E around 20 times.

It is challenging to see how either could rise given the narrative beginning to form around the abuse of supermarket power.

Listening to supermarket CEOs defend their practices could cause you to choke on their “Claytons” Barossa wine.

Take, for example, the claim that supermarkets need their suppliers to be successful for the supermarkets themselves to be successful. This is simple marketing spin that fails any understanding of the supermarket-supplier relationship. Coles has 8000 suppliers. The suppliers have only one Coles. One buyer (Coles) can choose which supplier is successful and which is destroyed, merely by rejecting their crop.

Profits are of course the reason for a corporate supermarket’s existence; companies exist to make profits and boards are compelled to maximise them for owners. The difficulty arises when the profit motives bumps up against basic community needs.

The CEO response to this observation is that Australia’s supermarket gross margins need to be higher because we have a smaller population and a much greater geographic spread.

In Britain greater competition exists between supermarkets and consequently gross margins (the difference between what a product costs the supermarket and what they sell if for) are lower, suggesting consumers get a better deal.

Former ACCC chair Rod Simms summarised it like this: “There is no doubt we are paying higher prices than we should … the supermarket sector is stunningly concentrated. When you get this much concentration you are going to get higher prices. It’s just a straight causal relationship, proved everywhere.”

What’s more, if the claims by supermarket CEOs were true, then the operating or EBITDA margins of the Australian supermarkets should be no higher than their British counterparts.

In Britain, the major supermarkets include Aldi, Lidl and Sainsbury. For the year to March 2023 Lidl reported a margin of just 0.3 per cent. Aldi UK & Ireland Group reported just 1.1 per cent. Sainsbury did better, generating a 6.65 per cent margin in the year to March 2023, but this number was down substantially on the 7.28 per cent from the year prior.

In Australia, Woolworths reported an EBITDA margin of 6.4 per cent in 2018, 6.6 per cent in 2019, 8.4 per cent (2020), 8.7 per cent (2021) and 8.5 per cent in 2022. Did the tyranny of distance in Australia decline in the pandemic? I don’t think so.

Meanwhile, Coles supermarkets reported EBITDA for FY23 was $3.157bn on sales of $36.746bn, equating to an EBITDA margin of 8.6 per cent.

Clearly, something will be have to be done. The government knows there are no points for holding another impotent inquiry. There are plaudits however for those who “do something”. What will that something be? The answer will be important for supermarket investors.

Here are some ideas:

The first is that so-called “specials” are deemed a complete farce. If a retailer wants to put a product on special, they should pay for it themselves. And to prove they’ve paid, they need to submit their reduced gross margin to a regulator. Regulating specials sounds challenging but technology and AI can now make it happen.

Second, the government and the regulator need to admit that they cannot inject more competition. The existence of geographic monopolies means competitors cannot affordably move next door to existing supermarkets.

The only solution then is to impose competition by breaking up the geographic monopolies. Australian supermarkets have had a vast amount of time and any number of opportunities to do the right thing but successive CEOs have understandably been incentivised to deliver greater profits and greater margins. What CEO wants to be named as having reduced margins and profits to deliver fairer outcomes to customers?

Capitalism cannot simultaneously deliver superior outcomes for shareholders and customers. I don’t agree with the Greens on much, but breaking up the big supermarkets and simultaneously regulating the fair sharing of future land acquisitions may be the only solution to ensure more competition.

If the negative sentiment particularly at Woolworths is to continue there could come a point where that stock could become attractive in the short term. But more broadly, I cannot see greater profit margins for supermarkets.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management. MIM holds investments in the Woolworths group