Supermarket heavyweights devise new weapons of war

Milk and bread may not suffice to squeeze out more market share, writes Colin Kruger.

With most of Australia's supermarket spending tied up between them, how do Woolworths and Coles maintain growth in a relatively stagnant market?

One answer was provided recently when Coles extended its grocery price war to the corner store. Coles is now offering its brand of milk at $2 for 2 litres at 600 Coles Express outlets, and has cut the price of its bread.

Woolworths matched the deal, ensuring Australia's $4 billion-a-year convenience store market will be under even more pressure. These stores were already caught in the crossfire after Coles and Woolies introduced cheap milk and bread to their supermarkets two years ago.

A report by the Australian Association of Convenience Stores for 2011 gave some indication of the damage. "Take-home milk and bread were affected by the heavily reduced everyday price in supermarkets with both categories in declining in value, milk by 6 per cent, and bread by almost 11 per cent," it said.

The targeting of the convenience sector went beyond cheap bread and milk. The self-service checkouts in Coles and Woolies supermarkets were also designed to entice convenience shoppers who would otherwise have gone to their corner shop.

According to the report, Coles said its own convenience channel, the Coles Express stores, experienced a fall in merchandise sales in the first quarter of last year as customers shifted their buying to supermarkets.

It isn't just corner shops and rival franchises - such as 7-Eleven - that are feeling the heat.

In April, the independent grocery wholesaler Metcash was forced to gut its convenience store wholesaler Campbells Cash & Carry because its regional customers were not able to compete with $1-a-litre milk from the supermarkets.

It is all unquestionably good news for Coles and Woolworths, which is being reflected in stock prices that are trading at multi-year highs. Woolies is up 19 per cent for the financial year to date, Wesfarmers has gained more than 25 per cent.

Their good fortune is expected to be underlined by the release of first-quarter sales results next week.

Both retailers are expected to benefit from the easing of food price deflation, which is evident from the recent release of consumer price index data.

It showed the food CPI was 0.3 per cent for the December quarter compared with minus 1.1 per cent for the September quarter.

The Deutsche Bank retail analyst Michael Simotas said that combined with strong volume growth over the holiday period, it "should result in solid sales announcements next week".

But concerns are being expressed about how much more growth the giants can wring out of the market.

Coles still has some natural headroom to grow as a result of years of underperformance under previous owners, as well as an underperforming liquor business that is finally threatening to compete with the Woolworths liquor juggernaut.

This means the big questions are being asked of Woolworths, which may be running out of easy growth options now that its largest rival has regained competitiveness.

In November, the Merrill Lynch retail analyst David Errington asked some tough questions of Woolies, which is having to work harder, and at greater cost, for any gains it is making in the market.

While Coles has been generating most of its sales growth from a relatively static footprint - which speaks volumes about the quality of its earnings - "Woolworths' earnings quality has been deteriorating for the past five years," Errington reported.

Its high-cost entry into the hardware sector with Masters is another potential risk.

Return on investment is falling as the company chases sales growth, says Merrill Lynch, which placed a $22 price objective on the stock in November at a time when it was trading at $28.50. The stock has added $3 since then.