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Abbott and Aldi target Woolworths and Coles

Retail giants Woolworths (ASX: WOW) and Wesfarmers-owned (ASX: WES) Coles are coming under sustained competition from independent retailers such as Metcash (ASX: MTS)-owned IGA and Foodland, as well as international discount brands including Aldi and Costco.

Increased competition is great for consumers as the price of a standard shopping trolley has remained the same for the last five years, despite many other household expenditures going through the roof. Coles and Woolworths are in a constant battle to lower prices in order to attract customers from each other, but also to stop the masses from moving to the alternatives.

While consumers benefit, the race to the bottom has damaged the local reputation of Coles and Woolworths as they have been seen to be negotiating too harshly with local suppliers and producers. In some cases, they’ve bypassed local producers completely and instead imported cheaper goods from overseas.

The government is having none of this and the Abbott coalition has vowed to support local industry’s fight against the tactics used by the big retail players. Small Business Minister Bruce Billson appears to be a vocal critic of the steps Woolworths and Coles have taken to maintain market share, saying “While intensified competition between the two major chains has reduced grocery retail prices, there are concerns that those reductions come at the expense of suppliers and impact on the longer-term durable benefit to consumers.” Evidence of this is the report last week that the $111 billion food and grocery sector has lost sales and jobs in the past year.

The question he is asking the community is whether “these price and market pressures impact on the viability of the food-and-grocery industry over the long term and will they stifle innovation and investment by suppliers? And will this result in higher grocery prices in the longer term?”

The thinly veiled stab at the two major players comes as the government has to make a decision on financially supporting local producers such as SPC Ardmona as job cuts have taken their toll on the industry.

But how does this all impact the investor? There are two lines of thought: the first is from the government and some media outlets, which have denounced Coles and Woolworths for pushing local producers to the wall by offering lower prices in their ongoing battle for market share. The other is from the companies themselves, which point to the 300 Aldi supermarkets on the east coast, and growing presence of overseas giants such as Costco in most major cities as the reason why they have to continue to push prices down.

Aldi sells only private-label products (for example Aldi Baked Beans), while Coles and Woolworths have traditionally sold the produce of third-party suppliers (think Heinz Baked Beans). Aldi can sell its products for much less than Woolworths can sell Heinz’s. Savvy shoppers are figuring this out and there is a good chance that we will see market share loss from Woolworths and Coles in coming years, especially if the government makes it harder for them to keep prices low.

Foolish takeaway

While this may contradict some analyses in the market, there is a very real threat that Australia’s two biggest grocery retailers, Coles and Woolworths, will face pressure from both the government (and greater Australia) as well as international competitors in coming years.

Their profit margins are being squeezed by competition from rivals and they are increasing private label products — often produce from cheaper international sources — in order to remain competitive. By doing this, they anger local producers and suppliers who call for government action, either by legislation or levies on imported goods. The outcome from this may be lower profit margins for the big two grocers, though there is still a long way to go in this debate.

Woolworths and Wesfarmers are currently yielding 3.81% and 4.19%, which has traditionally grown steadily as the companies innovate and move into new market segments. Those looking for another big dividend paying company should discover The Motley Fool's favourite income idea for 2013-2014 in our brand-new, FREE research report, including a full investment analysis! Simply click here for your FREE copy of "The Motley Fool's Top Dividend Stock for 2013-2014."

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

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