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Woolworths and Coles: Competition to squeeze margins in 2014?

Woolworths (ASX: WOW) and Wesfarmers  (ASX: WES)-owned Coles are facing increased competition from smaller Australian and international rivals attempting to undercut their way into Australia’s $120 billion food and liquor industry. While they are fierce rivals of each other, Coles and Woolworths are being targeted as one by international discount retailers Costco and Aldi, Coca-Cola Amatil’s (ASX :CCL) entry into the liquor market, and to a lesser degree the network of IGA stores across the country.

The five main players in the Australian retail food industry have vastly different approaches.

  • Woolworths and Coles have well-known and similar business models, and command the lion’s share of the domestic food and liquor market due to their long history in Australia.
  • Costco has operated in Australia for five years and operates five warehouses that stock almost everything (food and drinks, cakes, hearing aids, jewellery and clothes). It charges an annual fee for entry into the store and is based on the east coast currently.
  • Aldi, like Costco, operates in the eastern states and sells private label (Aldi-branded) groceries, electronics and everyday household goods like bathroom taps.
  • IGA operate small-scale, privately owned, stores across the country specialising in everyday groceries and liquor.

In terms of size, Aldi’s 305 stores (March figure) are believed to generate in excess of $5 billion, Costco generated $612 million in 2012/13, while Woolworths reported sales of $58 billion and Coles $36 billion in the 2012/13 financial year. IGA sales data couldn’t be found as they are private companies, however Metcash (ASX: MTS) supplies IGA stores and reported revenue of $13 billion in 2012/13.

Therefore, as a rough estimate it can be assumed that Aldi, Costco and IGA account for between 15% and 20% of the Australian food and liquor market.

What are they doing in 2014?

In 2014 analysts and market commentators believe that further pressure will be applied. Costco has received $110 million from its US parent company for an expansion into Adelaide and Brisbane in 2014, while Aldi is part-way through investing up to $2 billion in 115 new stores in Adelaide and Perth in the coming years.

But how will Coles and Woolworths be impacted?

The impact of Aldi and Costco on Woolworths and Coles cannot be underestimated. While estimating the revenue or margin impact is difficult, recent reactive strategy changes demonstrate the impact of competition.

Aldi’s big-margin private label brands have forced a rethink about stocking only big-name brands by Woolworths and Coles, while Costco’s $60 annual fee creates a sticky custom base unlikely to shop elsewhere.

Foolish takeaway

The Australian food and liquor market is constantly evolving as competitors enter with game-changing business models and ideas. Woolworths and Coles appear to be adapting well, but negative publicity in 2013 surrounding hard-line negotiation with Australian suppliers is one example of the pressure the companies are under to lower costs in an increasingly competitive marketplace.

Woolworths and Wesfarmers are loved by investors for their reliable, fully franked dividends, strong return on equity (Woolworths mainly) and market leading positions. Signs of deterioration in these factors may put investors off, however this Foolish investor believes that foreign competitors will struggle to meaningfully grow market share in years to come. Also, the management of both Woolworths and Coles has consistently shown how good they are at adapting to change.

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

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