Supermarket shares could keep falling on margin pressures

Metcash Limited (ASX:MTS), Woolworths Limited (ASX:WOW) and Wesfarmers Ltd (ASX:WES) all have a long road ahead.

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Metcash Limited (ASX: MTS) released a mediocre set of full year 2016 results in June, showing the persistent headwinds of increased competition and margin contraction facing the supermarket industry.

With both Woolworths Limited (ASX: WOW) and Wesfarmers Ltd (ASX: WES) slated to report full year results in August, now might be a good time for investors to reassess their supermarket holdings in light of Metcash’s results.

Metcash Limited

Metcash supplies the Independent Grocers Association (IGA) network throughout Australia. It is currently third placed in the battle for market share, behind industry leaders Woolworths and Wesfarmers’ Coles.

In June, Metcash reported its food and grocery division increased sales by 0.5% to $9.3 billion. Impressively, like for like sales grew 1.4% across IGA stores, representing the fourth consecutive period of sales growth. These results compare favourably to Woolworths’ third quarter update where same-store sales dropped 0.9%.

However, investors must bear in mind that these results are off a low base and given reported earnings (EBIT) declined 17% to $179.9 million in its supermarkets division, it appears intense competition is taking a toll on margins. This does not bode well for future profitability.

Woolworths Limited

Like Metcash, Woolworths’ supermarkets business is seemingly in a similar position of slowing profitability. Same-store sales in its flagship division dropped 0.9% over the March quarter, compounded by deflation in food and liquor prices. Total group sales decreased 0.3% over the third quarter.

Margins were also down in the first half by 55 basis points to 24.91%, indicating its underlying business is struggling to maintain momentum. This, in turn, results in a dwindling share price.

Wesfarmers Ltd

In my mind, Wesfarmers remains well placed to win the supermarket race with its wholly-owned subsidiary Coles firing on all cylinders.

In the March quarter, Coles lifted same-store sales by 4.9% which is an impressive feat when put in context of the 2% deflation to food and liquor prices over the quarter.

Importantly, Wesfarmers’ other businesses are performing strongly with Bunnings, Officeworks and Kmart reporting 11%, 17.9% and 5.6% sales growth over the third quarter, respectively.

Nevertheless, growth for the sake of growth is ill-fated, with Wesfarmers’ management highlighting margins across its Kmart, Target and Coles businesses decreased as a result of clearance and promotional activity.

Accordingly, even Wesfarmers’ shares remain captive to systemic industry pressures despite clear outperformance in its business units.

Foolish takeaway

Margin contraction appears endemic in the supermarket industry, attritubale in part to increased competition from discount chains Aldi and Costco. With these trends likely to continue, I believe the supermarket industry is best avoided for now.

Motley Fool contributor Rachit Dudhwala owns shares of Woolworths Limited. 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.

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