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Woolworths and Wesfarmers’ shareholders could face a tough 2014

Last year shareholders in both Woolworths (ASX: WOW) and Wesfarmers (ASX: WES) enjoyed share price gains of nearly 15% and 18% respectively. However, due to the potential for increased competition, the outlook for 2014 is perhaps not so bright for the owners of Australia’s two dominant supermarket chains.

According to a recent report in the Sydney Morning Herald (SMH) the USA-based Costco has funelled around $110 million to its local division Costco Australia over the past 18 months. Citing accounts lodged with ASIC, the SMH also reports that Costco Australia rung-up $612 million in revenues and made a profit of $1.81 million in financial-year 2012-13.

While Costco Australia is a long way off the levels of revenue and profits of major supermarket chains Woolworths, Coles (owned by Wesfarmers) and even IGA, which is owned by Metcash (ASX: MTS), the additional cash from its parent company should come as a warning to shareholders.

As Costco Australia rolls out its warehouse format at more locations across the nation, the appeal of paying for a Costco membership grows due to access to the chain becoming more convenient. At some stage Costco’s footprint in Australia should reach a tipping point; at this point the ease and appeal of heading to Costco could rival that of Woolies or Coles.

What this means for shareholders

The huge market share of the two major chains from an investment point-of-view gives them appealing economies of scale. The entry of Costco as well as Aldi into the domestic market is disruptive and has the potential to not only take sales and volume away from the two majors but also to shrink their margins.

On the other hand, while $110 million is a significant addition to Costco Australia, it is worth remembering the first mover advantage and significant goodwill the Woolworths and Coles brands enjoy in Australia. As Warren Buffett has reminded investors previously, there can be an enormous amount of hidden value in a company’s balance sheet in the form of prior expenditure on advertising and marketing. This expenditure does not show up as an asset on the balance sheet but can have long-lasting positive effects for a company’s brand.

Foolish takeaway

It’s not just Woolworths and Wesfarmers which stand to lose market share and margin to new competition. Other retailers including The Reject Shop (ASX: TRS) also need to review their strategies to deal with the likes of Aldi and Costco.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

 

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