Should you sell Woolworths Limited, Wesfarmers Ltd and Metcash Limited?

Investors are starting to realise that Woolworths Limited (ASX:WOW), Wesfarmers Ltd (ASX:WES) and Metcash Limited (ASX:MTS) could face a serious competitive threat from Aldi.

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Last week investors were treated to a report by Moody's Investment Services which analysed the state of the Australian supermarket industry and specifically the long-term challenge which German-based retailer Aldi poses to Woolworths Limited (ASX: WOW) and Coles, owned by Wesfarmers Ltd (ASX: WES).

Amongst the conclusions drawn by Moody's was that Aldi had already inflicted significant damage on wholesaler Metcash Limited (ASX: MTS), which is a grocery supplier to independent retailers. Indeed the drop in profits at Metcash and the slump in its share price – the stock is down over 52% in the past year – could most likely be attributable to Aldi rather than our two domestic supermarket giants.

While the competitive threat that Aldi poses to independent supermarkets is perhaps well understood by investors already, the primary conclusion that Moody's highlighted is perhaps yet to be fully appreciated by investors. The conclusion drawn was that Aldi also poses a long-term challenge to the market share and earnings power of Woolies and Coles.

Moody's believes that this Aldi's competition will force Woolies and Coles into a defensive response to defend their market share. According to Moody's and based on overseas examples, this inevitably will mean tighter margins and hence lower earnings.

With Aldi forecast to grow its store footprint on the east coast at around 5% to 6% (according to Moody's), the group will be on a growth trajectory double that of Woolies and Coles. Looking west to South Australia and Western Australia, Aldi's store growth is set to be even greater as it enters these markets.

Shareholders in Woolworths and Metcash have already been hit with both stocks trading near multi-year lows.  While Wesfarmers' conglomerate structure provides a diversity of earnings and some protection, Coles is the single biggest driver of the group and investors will need to watch how Coles responds to the Aldi threat closely.

In short, despite the lower prices on offer from these leading stocks, investors could be best off taking a cautious approach given the expected headwind which could see a long grind down in margins.

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

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