Woolworths Limited (ASX: WOW) and Wesfarmers Limited (ASX: WES) – owner of Coles, both saw their share prices jump by over 3% yesterday. A report from market research firm, IBISWorld, has suggested that private label (for example, Woolworths Select, You’ll Love Coles and Black & Gold) products will account for more than 33% of grocery sales within five years.

According to the report, consumers have doubled spending on private label groceries over the past few years, going from $10 billion in 2008 to $20 billion in 2012. Retailers’ home brands now represent 24% of supermarket sales, and spending on private label brands is expected to reach $32 billion by 2018.

The big retailers make more profit on their private label products, which should increase their current margins as sales grow.

Sir Terry Leahy, former boss of UK retailer Tesco, has told The Sydney Morning Herald that there are limits to how much private label goods can dominate their shelves. For Tesco, that limit is around 40 to 45%.

According to The Sydney Morning Herald, Woolworths and Coles are believed to have a private label penetration of between 10 to 15% (which is lower than the IBISWorld report). US stores Kroger and Safeway have closer to 25% private label penetration, while Walmart and Britain’s Sainsbury’s have more than 40%.

Another issue for the big retailers is that they have to make sure that they pay the private label suppliers enough to ensure their products are safe, high quality and attractive. For Woolies and Coles to apply pressure to drop costs could see them suffer reputational damage, because the products now have their name on the label.

It’s more bad news for Australian producers and manufacturers as their brands get squeezed off the shelves, coming on top of pressure from the supermarket giants to slash their prices. Manufacturers may need to choose between concentrating on their brands only or private label products.

Alternatives for suppliers

Some manufacturers have turned to online grocery retailers, such as GroceryRun.com.au, Supermarketdeals.com.au and OffYourTrolley.com.au. Heinz, most well-known for its baked beans, was forced to closed a factory late last year due to the withering competitive environment, and now sells some of its products through the online sites. SPC Ardmona, owned by Coca-Cola Amatil Limited (ASX: CCL), is likely to be facing the same pressures.

Stacey Carlon, founder of Off Your Trolley has also told The Sydney Morning Herald, that there is no shortage of manufacturers embracing online sales as a way of addressing some of the challenges they face as a result of Coles and Woolies’ focus on private label products.

Another company that could benefit from the supermarket war is Metcash Limited (ASX: MTS). If Coles and Woolies push manufacturers too far, we could see suppliers divert their branded products to IGA supermarkets, which may draw customers away from Coles and Woolworths.

The Foolish bottom line

It’s a fine line that the big two supermarket retailers are walking. Push too hard, and they could end up losing customers and sales – not enough and they could see their margins eroded. Who’d want to be a retailer?

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Motley Fool writer/analyst Mike King owns shares in Woolworths. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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