Why Woolworths Limited will lose a price war with Coles

Credit: Scott Lewis

With the Woolworths Limited (ASX: WOW) share price sitting at a price not see since 2006, it’s abundantly clear Coles, bought by Wesfarmers Ltd (ASX: WES) in 2007, is winning over shoppers.

Sure, Woolworths’ supermarkets were the crown jewel in its portfolio for many years. However, its willingness to gouge consumers for wider margins and extra profits has now come home to roost.

Indeed, the heady days of 7% profit margins within Woolworths’ Australian Food, Liquor and Petrol division — compared to the 4% to 5% Coles generates for Wesfarmers — appear done and dusted. Woolworths was one of the most profitable supermarkets in the world.

The bigger they are the harder they fall

A declining profit margin is particularly important for Woolworths because it is the company’s primary profit generator and it’s a volume business — meaning it’s very sensitive to changes in profit margins.

By contrast, coming off a smaller base (in terms of profit margin) the Coles business could continue to generate profit growth until industry margins reach, what economists would call ‘equilibrium’.

Moreover, if we factor in consumer perceptions, which play a powerful role in retail, many of us are likely to continue going to Coles and Aldi for some time, even if prices are cheaper at Woolworths.

Rewards without profits

Woolworths recently began trialing its new rewards program, after it decided to cut Qantas Frequent Flyer points from its loyalty program in a bid to cut costs.

Following the launch of the new rewards program, published an article entitled: “Shoppers want lower prices, not rewards”

And it’s true.

If Woolworths experiences a significant decline in market share as a result of the recent trends, you can bet Woolworths will continue to lower prices — as it has done recently. That’s good news for those consumers still shopping at Woolies, but it’s bad news for shareholders.

Lower prices equal lower margins and eventually lower profits. Indeed, as any investor or analyst will tell you, the only way to maintain profitability is to lower costs.

That’s something Woolworths and Coles have already explored. Private label products and allegedly poor practice with farmers and suppliers have become the norm. Then, automated checkouts and expansions into complementary services like mobile phones, insurance, credit cards and online ordering have been identified as the low hanging fruit. But they aren’t going to move the dial significantly. At least not anytime soon.

Foolish takeaway

Consumers have voted with their feet and wallets. More of us are choosing Coles and Aldi. With the perception of being more expensive, Woolworths appears to have just one strategy left. Lowering prices.

If it hasn’t already, it risks starting an all-out price war.

Rather than supermarkets, I'm looking for other - faster growing - dividend shares to add to my portfolio, like the one The Motley Fool's expert analysts hand-picked as their best dividend share idea for 2016.

Indeed, our resident dividend experts named their Top Dividend Share for 2016. Not only are the shares dirt cheap, the company is growing and trading on a 5.6% fully franked dividend yield. Simply click here to gain access to this comprehensive FREE investment report, including the name of this fast growing ASX dividend share. No credit card required!

Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any company mentioned. Owen welcomes -- and encourages -- your feedback on Google+, LinkedIn or you can follow him on Twitter @ASXinvest.

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.