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Why Woolworths, Coles won’t cash in on rising food prices


The price of food is soaring, but investments in the big 2 supermarkets are not, an industry expert warns.

Morningstar warns in its latest report that food inflation is "well and truly underway" in Australia, but it queries whether it will be a long-term win for Woolworths and Coles.

In its update to the market, Morningstar suggests that rising revenue could counteract the rising cost of goods sold, higher energy prices, weak population growth, greater out-of-home food consumption and temporarily bloated supply chain costs because of COVID-related disruptions and demand volatility.

However, Morningstar's director Johannes Faul believes this is a "fleeting benefit for the supermarkets".

"We forecast this tailwind to moderate from fiscal 2023, with food price inflation averaging around 2.5% in the subsequent decade," he said.

"The Australian government expects inflation to moderate over the medium term too. In its latest federal budget, the government forecasts consumer prices to increase by 4.25% in fiscal 2022, before inflation eases to 3.00% in fiscal 2023 and 2.75% in fiscal 2024."

The Reserve Bank of Australia (RBA) largely agrees.

During its latest meeting on Tuesday, the central bank noted that headline inflation remains above its target range of 2–3% (currently at 3.5%). It did not raise rates given it is unsure whether inflation is set to remain high.

"Higher prices for petrol and other commodities will result in a further lift in inflation over coming quarters, with an updated set of forecasts to be published in May," RBA governor Philip Lowe said.

"The main sources of uncertainty relate to the speed of resolution of the various supply-side issues, developments in global energy markets and the evolution of overall labour costs."

What does this mean for Woolworths and Coles share prices?

With a spike in inflation only being temporary, Morningstar says it is unchanged in its value for the big 2 supermarkets.

And it is potentially bad news for investors.

Faul said that the value estimates for Woolworths and Coles remain the same at AUD$25 and AUD$13.60, respectively. Given that Woolworths is currently trading at $37.15 and Coles at $18.10, both share prices could be expensive.

"Both supermarket operators screen as overvalued, but on relative valuations, we prefer no-moat Coles over narrow-moat Woolworths," Faul said.

"Current share prices suggest the market is more optimistic on the profit outlook for Woolworths and Coles. However, we expect structural challenges to limit their sales and earnings growth at around 4% over the next decade."

But what if inflation remains?

The analyst notes that it does not believe food inflation will remain as competition among Woolworths, Coles and Aldi forces the supermarkets to drop prices. He acknowledges that if inflation remains, it could be a tailwind for the 2 supermarkets' share prices.

"A prolonged period of inflation above our base case estimate could drive greater sales and earnings growth and present an upside risk to our fair value estimates for Woolworths and Coles," Faul explains.

High inflation will impact share valuations across the market, putting equal pressure on Woolworths and Coles as everyone else.

"However, we expect stubbornly high inflation, above the Australian Reserve Bank's 2–3% target range, to trigger interest rate hikes, in turn weighing on price to earnings ratios and their inversion, earnings yields," Faul concludes.

Disagree with Morningstar and are keen on Woolies or Coles?

If you are keen to buy shares in Woolworth's or Coles consider investing through an online share trading platform.

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