The battle of the supermarkets is closer than ever, but one still stands out

Anna Milne, CFA, equity analyst for Wilson Asset Management, has a preference for Woolworths but views both as strong companies to continue to hold in 2023.

“Their earnings are extremely defensive and, aside from the normalisation post-covid, their earnings are growing. This is more than you can say for a lot of other names when we’re staring into an earnings downturn,” she says.

She also notes that while Woolworths has traditionally been viewed as the more premium holding, the gap has narrowed with the companies trading on the smallest PE differential that they have had in years, less than five times.

In this wire, we discuss the results for Coles and Woolworths and why Milne sees the future as bright for supermarkets.

One-year share prices for Coles

One-year share prices for Woolworths

Note: This interview took place Wednesday 22 February 2023. Woolworths and Coles are holdings in the Wilson Asset Management portfolios.

Coles Group (ASX: COL) 1H 2023 results

• NPAT up 11.4% to $616m
• EBIT up 9.9% to $1.058bn
• Total sales revenue up 3.9% to $20.8bn
• Supermarket sales revenue up 4.6% to $18.85bn
• Liquor sales revenue down 2.4% to $1.95bn 
• Interim dividend 36c
• Earnings per share up 17.2% to 48.3c

Key company data for Coles

Woolworths Group (ASX: WOW) 1H 2023 results

In one sentence, what was the key takeaway from these results?

Strong performance with a robust outlook amid broader market uncertainty.

What was the market's reaction to this result? In your view was it an overreaction, an underreaction or appropriate?

Appropriate to slight underreaction at some points during the day. 

It did rally. Woolworths in particular rallied strongly from the result and has deservedly seen further strength today given the earnings upgrades that are going to come through. I expect it to rally around 2-3%. It opened around this amount, fell and rallied during the call as we got more colour on the earnings outlook. 

In the context of the expected changes and earnings forecasts, it feels appropriate and a dividend beat should always be rewarded.

It's broadly similar for Coles.

Were there any major surprises in the results that you think investors should be aware of?

The points of interest came out of Woolworths in particular.

While food was strong, Big W drove a lot of the beat. That shouldn't come as a big surprise given other consumer discretionary names, such as Wesfarmers (ASX: WES) who own Target and Kmart, presented strong results. It's certainly not a strength we would extrapolate into the second half. We're facing a much tougher environment in the second half and management called out their expectations for the second half to be a lot weaker. They said the first half is going to account for 75-80% of full-year earnings - they know they're in good shape but don't expect the strength to continue if we're looking for negatives.

If we compare Woolworths to Coles, their food growth was a little bit below Coles but the composition of the numbers is different. Woolworths has been stronger for online sales and that was understandably stronger last year given covid impacts. Compositionally, I think it's fine and the relative strength of Coles v Woolworths was in consensus - that is, still ahead of the market.

Would you buy, hold or sell on the back of these results, and which is your preferred name?

HOLD

Our preference is for Woolworths but we do hold both names and will continue to hold them off the back of these results.

What's your outlook on Coles, Woolworths and the sector over the calendar year for 2023?

It always has to be a relative call versus the rest of the market. 

Their earnings are extremely defensive and, aside from the normalisation post-covid, their earnings are growing. This is more than you can say for a lot of other names when we’re staring into an earnings downturn. 

It doesn't take a model to work out that there'll be more spent at the supermarket when budgets are tight. [Woolworths] said on the earnings call today that they are beginning to see, even in the last few weeks, increased trends to suggest less eating out, more eating at the supermarket. Within the supermarket, there's been trading down from fresh foods to canned or frozen, for example.

You're paying around 15% more than the five-year average valuation, but in my view, this feels justified. When you're comparing Woolworths and Coles, Woolworths has always traded at a premium to Coles given it's considered to be higher quality, proven management, better technology and systems. They're trading on the smallest PE differential in years. It's less than 5x. Woolworths is on 27x, Coles is around 22x so that gap has really narrowed. 

From here, Woolworths is the preferred play.

One hesitation I had with Woolworths was they are cycling a stronger period in their online sales, but their current trading outlook noted e-commerce is returning to growth.

What are your thoughts about the new CEO announced by Coles, Leah Weckert?

She is proven to be a good operator. The market already knows her. So there is some certainty in that regard. However, with any incoming CEO, there's change. There's a potential change in strategy. If she chooses to be more aggressive in gaining market share, it could present some downside risks to industry profitability.

Are there any risks to these companies and the sector that investors should be aware of given the current market environment?

Mainly the potential changes from the incoming CEO for Coles. The market has been quite rational for a while now and it's uncertain, with new management, regarding what strategy is pursued. That's a downside risk. 

Overall, I think the entire industry is in a great position in the more challenging economic environment. It feels like a safe place for us. It's not extremely expensive and growth and safety can be paid at a premium so we're happy with both these names.

From 1 to 5 where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or cautious about the market in general?

Rating = 3

When we think about the market, we're thinking about the earnings environment and valuations. They are two quite different topics.

On the economic environment and earnings - that is clearly getting worse. We're been forewarned. We've seen it through global leading indicators turning negative and the well-flagged mortgage cliff and the coincident data is really just starting to turn. We're starting to see it in the earnings transcripts. For example, in the last two weeks, things have changed and we're seeing this in the credit card data. It does feel like there has been a notable change in temperature for the economy. 

On the other side of the equation is valuations, which are a bit tricky and come down to whatever the RBA decides to do. And by inference, the Fed. We're nearing the upper limits for the cash rate but we think Mr Lowe is going to remain hawkish until the end, to make sure his messaging for the need for cooling consumption really does resonate.

We're watching jobs data for clues. As soon as there is any hint that the hiking cycle might be over, valuations will have troughed. We're balancing slowing earnings with the prospect of easing financial conditions at some point this year. 

So, we're in the middle of the pack. We're a three.

10 most recent director transactions for Coles

10 most recent director transactions for Woolworths

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