What's Woolworths worth? - Part 1

He gets most of the credit, but it probably didn't take a genius like Isaac Newton to tell people that what goes up must come down. In finance, the proposition typically gets expressed as 'reversion to the mean', which sounds a lot grander but comes to much the same thing; and it's fair to say that supermarkets in the UK have been doing a lot of it lately.

The legendary Tesco has seen the operating margin at its UK business fall from 6.1% in 2012 to 2.1% in the six months to August – and it's forecast to get worse before it gets better.

All this has caught investors on the hop, with the share price halving since September last year, to £1.88. Even Warren Buffett has copped a bloody nose, having bought a (now reduced) stake at over £3.

Fellow UK listed supermarket groups Sainsbury's and Morrisons haven't fared much better, falling 42% and 39% in the same period. Naturally this has got people wondering whether the same fate could befall Woolworths over here, and it has now fallen around 15% in six weeks in sympathy with its UK peers (it wasn't helped by a disappointing first-quarter sales update).

Ominous similarities

There are ominous similarities in a couple of key areas – the rise of discounters like Aldi and the increase in internet shopping. In this three-part series, we'll look at these problems and consider how they might affect Woolworths (and the Wesfarmers-owned Coles).

We'll start in this first part by examining the threat from discounters such as Costo and Aldi. In part two, we'll consider the impact of the internet before returning to the overall level of competition – or lack of it – in the Australian market. Finally in part three we'll look at what it all might mean for Woolworths' margins and valuation, and whether it too will end up demonstrating Newton's law.

Before we start, though, we'll let slip a little of the punch line, because it's important to understand the context of the various issues. Despite the similarities, there's a major difference between the Australian and UK markets in the intensity of competition. Notwithstanding Aldi's considerable success, the Australian market still operates as a quasi-duopoly. The UK, by contrast, has four players with market shares between 10% and 30% and a clutch more between 5% and 10% (See Charts 1 and 2).

This exacerbates the underlying problems in the UK: the presence of discounters is made worse by a willingness to match their prices; the over-reliance on out-of-town superstores is made worse by the need to earn something from the massive fixed investment; and the rise of the internet is made worse by the reluctance of the majors to extract an appropriate charge for it. We'll return to this towards the end of Part 2, but for now let's turn our attention to the discounters.

Land of the giants

Walking into a Costco has been likened to entering the land of the giants. There are relatively few stores, but they are BIG, and everything is sold in BULK – after all, you don't want to travel all that way too often. With cheap locations and bulk deals Costco is able to offer cheap prices on premium brands, but you have to pay an annual membership and relatively few people have the time or inclination to travel that far not knowing exactly what will be in stock (the company refers to it as 'the treasure hunt').

Costco now has seven Australian stores, after opening its first in 2009, but with an estimated $1–2bn in annual sales it's a small part of the $92bn Australian grocery market and we expect it to remain a niche player. Even in the US, where it has been going for 30 years and has 450 stores, its share of the overall grocery market is only about 5%.

Parallel universe

If entering a Costco is like walking into the land of the giants, visiting an Aldi is like stepping into a parallel universe. The smoked salmon comes in a blue packet with a transparent leaping salmon, but it says 'almare' rather than 'tassal'; the English breakfast tea comes in a crested red box but says 'Diplomat' instead of 'Twinings'; and the diced Australian tomatoes come in black tins with a red and white logo that says 'Remano' rather than 'Ardmona'.

If you look closely, you'll see that almost all these otherworldly brands are owned by Aldi, with the products being made specially for it by third parties. Some have suggested that the similarities to familiar brands might confuse consumers, but Aldi says it just gives shoppers visual cues about the nature of the products: red indicating English breakfast tea, for example, and black tins indicating Australian tomatoes.

The thing is that Associated British Foods and Coca-Cola Amatil (the respective owners of Twinings and SPC Ardmona) have spent large sums creating these associations with their own products – and that of course is the very reason that they cost so much more (see Chart 3).

Whatever the legal situation (we'd guess that Aldi are sailing close to the wind but have an idea what they're doing), customers are voting with their feet: given the choice they'd rather not pay the extra to be advertised at. This has propelled Aldi from a standing start in 2001 to over 10% of the local market, according to independent research from Roy Morgan (see Chart 2), overtaking the hapless Metcash/IGA in 2013.

Ramping up private label

The point has not been lost on Woolworths and Coles, which have been ramping up their own private-label offerings in recent years, with the added twist that they've used their existing goodwill to give their labels a jump start. At different price points and in different categories, Woolworths and Coles now offer a range of private-label products, some with much improved packaging from the 'no-frills' offerings.

All this isn't so much of an issue for the fresh produce that contributes around a third of grocery spending. These products don't lend themselves so well to branding and suppliers have already been beaten down in price. But it has created a major headache for the premium brands, and we'd suggest it's behind the recent weak performances from the likes of Coca-Cola Amatil and Goodman Fielder.

Woolies and Coles, though, are a step back from the front line; indeed they're in the same position as Aldi. They just need to make sure they provide products that customers want to buy at prices they are willing to pay – and they've made it clear to suppliers that they will do exactly that, whether it be a premium brand backed by heavy marketing or – increasingly – a cheaper brand of their own.

Leading the charge

We suspect that many suppliers will continue to struggle to get their heads around this, and that private label will continue its rise. According to IBISWorld, private-label sales have grown from 14% in 2007-8 to around 25% now, and the researcher expects them to reach 35% by 2019-20.

Woolies and Coles will no doubt be delighted to lead the charge because own brands give them higher margins, and/or greater scope to cut prices to compete with the discounters (although they presumably do better out of their mid-priced rather than budget brands).

In fact the increase in private label thus far is a major reason they've been able to maintain their combined market share, while increasing margins, despite Aldi marching ahead. In fact most of Aldi's gains have come at the expense of Metcash's IGA network and 'other' (see Chart 2).

No doubt Metcash/IGA has been pushing its own private-label goods, but it is facing bigger problems, notably its distribution-focused business model and the lack of control over its store network, as we explained in Metcash model is fundamentally flawed on 23 Mar 14 (Avoid – $2.85).

Convenient stores

Aldi does have one edge over Woolworths and Coles – at least for part of the market – in the smaller footprint of its stores and limited range. Part of the problem in the UK has been a massive misreading of the market a decade or two ago, which led the large chains to build a huge number of stand-alone, out-of-town superstores. These now account for 42% of UK grocery sales, but they're finding that to lure people to them, they have to be very competitive on price at the same time as carrying huge ranges (you wouldn't want to have to travel to more than one of them).

Australia has virtually none of these out-of-town superstores, favouring the medium-sized format so often seen in shopping centres, but Aldi nevertheless gets an edge from its more limited range and convenient sites. The former means it can compete hard on price on the stocked items, while the latter means customers are happy to pop in for just part of their overall shop.

The balance has proved compelling for some, but it won't work for most of the market – plenty of time-poor shoppers would rather get it all done in the one shop, especially as Woolworths and Coles start to compete harder with their own private-label products.

Well placed

The added value is in giving consumers the products they want, at prices their prepared to pay, in a convenient fashion, and Woolies and Coles remain as well placed as anyone to do this.

Overall, we suspect Aldi will find it hard to push its market share beyond the mid-teens and we're in good company with that view, with Aldi Australia's joint managing director Stefan Kopp recently suggesting that Aldi would 'grow to a certain size and we might become No.3, but we'll never be a big player, or even close to the size of Coles and Woolworths'.

The reason Aldi and Lidl have had such a disproportionate effect in the UK is less to do with them and more to do with the overall competitive nature of the UK market. We'll turn our attention to this, and the threat from the internet in Part 2.

Note: The model Growth and Income portfolios hold shares in Woolworths.