Supermarket shares could keep falling on margin pressures

Fruit market

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.

Instead, a better place to invest your cash are these 'new breed' of blue chips that could take your portfolio higher in 2016

Forget Metcash and Woolworths. These 3 "new breed" top blue chips for 2016 pay fully franked dividends and offer the very real prospect of significant capital appreciation. Click here to learn more.

The report is free! No credit card required.

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.

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.