Are Coles and Woolworths struggling?

Private labels are dominating grocery spending.

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With the relatively recent entrance of German chain Aldi and US chain Costco (Nasdaq: COST) into the local market, the profit margins of Australian supermarkets Woolworths (ASX: WOW) and Coles (owned by Wesfarmers (ASX: WES)) have come under pressure. This has resulted in Coles and Woolworths aggressively adding private label (or in-house) brands in order to boost margins.

Recently compiled industry research has drawn some interesting conclusions. It found that the competition among the big four has pushed a basket of staple goods to the lowest level in 10 years when the best deals from each store are collated. Independent research released last week by Coles identified that steady cost-cutting has dropped the price of a Coles sample basket from $100 in 2008 to $96 this year. Not to be outdone, Woolworths Supermarkets director Tjeerd Jegen said that the 19 consecutive quarters of cost-cutting has resulted in Woolworths being 1% to 1.5% cheaper than Coles across 10,000 everyday items.

But where does this leave investors? Woolworths and Coles are reacting to competitors' lower pricing by providing more private labels instead of big-name brands. This aggravates produce suppliers such as Coca Cola Amatil (ASX: CCL), which owns SPC Ardmona, because they are forced to accept lower prices from the supermarkets who now favour private brands. This, in turn, damages the Woolworths and Coles brands as they are seen to be 'robbing' local Australian producers of the profit they deserve.

All of these factors point to the two big Australian supermarkets having a fight on their hands to retain market share, as Aldi and Costco expand around Australia. It's not all bad news though, as Coles and Woolworths are now doing more to build a 'network effect' into the brand by expanding their offering to items such as car insurance, banking, and mobile SIM cards, while their respective rewards schemes appear to be effective at retaining customers. I, for one, am loyal to Woolworths for its superior self-checkout lanes and link with Qantas (ASX: QAN) frequent flier points.

Foolish takeaway

Woolworths and Coles are facing serious and sustained competition. Investors should be aware that competition may crimp profitability in future years, especially if Aldi and Costco have success and expand into all Australian states.

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Motley Fool contributor Andrew Mudie does not own shares in any of the companies mentioned.

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