Preparing for the retail wars

In last issue (Long Term Buy - $7.45), we noted that Woolies had turned in a good three months to 1 October with supermarket revenues laughing off GST fears to rise 10.7% compared with the previous corresponding period. All heartening stuff. But give us a parade and we'll try to rain on it.

Raising concerns

We've come up with two factors which raise concerns about the company. One, a potential economic downturn, we've discussed pretty thoroughly in recent issues. Our opinion is that the economy will slow down next year as interest rates rise - although by how much is still an open question. This will inevitably lead to lower sales and slower growth at Woolworths. But we've been wrong about economic factors before and have been surprised by the continuing strength we've seen. We'll just have to keep an eye on things.

The second factor, though, we haven't looked at in detail for some time. That is the prospect of a bitter competitive war breaking out with the introduction of the aggressive German retail chain, Aldi and speculation that US supermarket chain Wal-Mart may have Woolworths' market share in its sights. It's Aldi which has us more worried.

Investors are also sniffing the wind. We saw this early in October with the reaction to news that Aldi may open up here later than expected. Woolies shares surged.

The Aldi formula, honed by the company's founders Theo and Karl Albrecht, is of the stack 'em high, sell 'em cheap school of retailing. Now while that's not to everyone's taste, the experience of Aldi opening in the UK shows that plenty of people were happy to sacrifice the relatively up-market halls of Sainsbury and Tesco to chase bargains.

Precarious position

Aldi's entry in 1990 triggered frantic discounting by everyone - good news for consumers, but not for investors. The carnage caused by Aldi's British adventure nearly took the former leading discounter, the Kwik Save chain to the wall. It's still in a precarious position.

Aldi, a private group of companies, first stepped outside the Fatherland in the late 1980s. Its impact on food retailing establishments has been dramatic wherever it has gone. The key is Aldi's prices - typically 30% below other supermarkets. This is hard to resist for a mum shopping on a budget with a lot of hungry mouths to feed. Loyalty doesn't come into it and if it means shopping in a bare, glamour-free warehouse, so be it (not that there's anything particular sexy about the weekly supermarket shop as it stands). The effect is a vice-like squeeze on profit growth figures for other players that doesn't go away.

The problem is that conventional supermarket operators are in a bad position to compete. Their whole corporate and public image is at stake. Do they change to look like Aldi? Do they dig in their heels and spend more on service? Do they set up a new division to compete? It's a real problem.

So what will happen? The carnage among little guys - some 4,500 independent supermarkets and convenience stores - will be like a bad day on the Somme. Already in a perilous and unenviable position, this will put the squeeze on them to such an extent that many will just close. Aldi gets market share and Davids (the main supplier) faces real trouble.

Next hardest hit will be the existing budget food retailers such as Franklins and Coles Myer's Bi-Lo chain. Profits will be squeezed here and they will have to shed staff or change to some degree

Woolies and Coles Myer's up-market supermarkets are probably in the best position of all and have some breathing space to build defences. Aldi plans to build 50 stores in Sydney and then to expand across the country. That's expensive and hard work just finding the sites. It will take time.

But Woolies and Coles will have to invest during this time to fight back. Strategies will include increasing their own house brands and generic products - a big factor in Aldi's success. This will cut into the bottom line.

So what does all this mean for the share price? Aldi will to some extent break up the cosy little party Woolworths and Coles have been enjoying for so long and lead to cost-cutting, discounting and involve extra investment to address the competition. That could cause investors to run scared and many will shed the stock. This will cause it to plateau (at best) the closer it gets to Aldi's entry - whenever that is. Wooolworths is still a great company, but at these higher prices and while the Aldi cloud hangs around we're going to be more cautious and say HOLD.

Mind you, with steady revenue streams and dividends, any weakening of the share price due to the German advance should be looked at as improving the dividend yield. It would not take much to change our minds to accumulate on any weakness nerves about Aldi may bring.