Supermarkets war heads for the corner

How much more growth can the two giants wring out of the market, asks Colin Kruger.

WITH most of Australia's supermarket spend 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 shop. Coles is now offering its home brand milk at $2 for two litres at 600 Coles Express outlets, and cut the price of its Coles-branded bread.

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

A report by the Australian Association of Convenience Stores (AACS) for the 2011 calendar year 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," the association 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 otherwise would have gone to their corner shop.

According to the AACS report, Coles said its own convenience channel, the Coles Express stores, experienced a decline in merchandise sales in the first quarter of 2012 as customers shifted to supermarkets.

It won't just be corner shops and rival franchises - such as 7-Eleven - that will feel the heat.

In April last year, 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 supermarket giants.

After Metcash's first-half results in November last year, analysts were reporting that the company was losing marketshare, and revenue in its core food and grocery business for the first time.

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

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 (CPI) data.

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

Deutsche Bank retail analyst Michael Simotas said that, combined with strong volume growth over the key 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 Australian 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. It may be running out of easy growth options now that its largest rival has regained competitiveness.

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

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 reports.

Despite a costly new store and store-refurbishment program, sales growth has been declining and reported earnings growth before interest and tax has relied on gross margin expansion - at the expense of suppliers - which cannot continue indefinitely, according to the broker.

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 slapped a $22 price objective on the stock in November last year at a time when it was trading at $28.50. The stock has added another $3 since then.