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Woolworths Group Ltd and Wesfarmers Ltd face derating from Supermarket War 2

The dust has barely settled on the last bruising supermarket price war between the majors and offshore competitors and there are already warnings that another painful war is about to erupt.

That’s the assessment from Morgan Stanley after the broker had a close look at the next German invasion with Kaufland set to make a beachhead on our shores in 2019 or early 2020.

This is particularly bad news for Woolworths Group Ltd (ASX: WOW) as our largest supermarket chain has only recently enjoyed a market re-rating as investors flocked back into the stock on signs that it is winning back market share at a faster-than-expected pace.

Sentiment towards the sector has also improved sharply this year as the battle with German discount grocery retailer Aldi moves into the next phase where price cuts and deep discounting that led to food price deflation have taken a backseat.

Analysts have even looked at the planned spin-off of the Coles Supermarket chain from Wesfarmers Ltd (ASX: WES) as a positive sign that rational behaviour is starting to prevail in the sector.

This calm won’t last, according to Morgan Stanley.

“Kaufland’s entry to Australia likely limits market growth, reduces the prospects for considerable margin expansion and leads to a sector P/E [price-earnings] de-rating,” warned the broker.

While Kaufland is similar in many ways to Aldi, the new Australian player prioritises fresh food and operates with a low margin business model.

Why this is bad news is because Coles and Woolies have used fresh food as one of the key ways to fight Aldi, which has a poor record in this area.

The two incumbents have been taking market share from independent fresh food grocers too with Morgan Stanley estimating that the market share of independents has fallen to 34% from 46% since 2007.

Aldi is revamping itself to improve its fresh food offering (a program called Aldi 2.0) and Kaufland’s arrival will make it all that much harder for Woolies and Coles to gain any more market share in this category.

If that doesn’t scare shareholders in Woolworths, Morgan Stanley sees a 52% downside for the stock under a scenario where current conditions remain weak for supermarkets, the two Aussie supermarkets cede market share to the German discounters (not to mention the potential impact of Amazon.com if it chooses to sell groceries) and margins revert back to global averages.

The broker has an “underweight” rating on Woolworths and Wesfarmers, and it thinks the only one in the sector worth buying now is Metcash Limited (ASX: MTS) as it is less impacted by the next Supermarket War in the fresh food isle given that this category has never been its strength. It is also diversifying into hardware.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. 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 Scott Phillips.

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