Why shares in Wesfarmers Ltd (ASX:WES) could come under pressure

The share prices of our supermarket stocks have enjoyed a renaissance of sorts since the end of the industry price war and grocery inflation, but things could be about to change.

The latest survey by Morgan Stanley found that price difference across a range of goods sold at Aldi and Costco versus Woolworths Group Ltd (ASX: WOW) and Wesfarmers Ltd’s (ASX:WES) Coles supermarket chain is starting to widen significantly – from circa 20% in October last year to 27%-28% at the end of July this year.

This is a negative for two key reasons. The first is that it increases the probability of another bruising supermarket price war, which had weighed heavily on the margins of Woolies and Coles.

This time round though, the widening in the price gap isn’t caused by offshore rivals cutting prices, but by not lifting prices when the Australian incumbents are.

The other implication of this is that the anticipated recovery in sales growth that is factored into the share prices of Woolworths and Wesfarmers may not eventuate – at least not to the extent that analysts are counting on.

Rising grocery prices are one of the key supporting arguments for buying these stocks, but that is predicated on the assumption that the price rises are sustainable (meaning no players trying to undercut each other).

But Aldi and Costco’s decision to hold prices steady may be more defensive than offensive. Morgan Stanley believes that Aldi and Costco may not want to give a pricing advantage to new entrants like Kaufland and to exploit and use as a foothold into the market.

There are other potential reasons for Aldi and Costco’s pricing decision. These groups may be taking a long-term view and are unconcerned about profitability in Australia in the context of their global operations.

They may also be better able to absorb costs as they spend around 5% of sales on labour and electricity compared to 12% for Woolies and Coles.

Morgan Stanley’s pricing analysis on 197 products sold at Aldi in July 2017 versus July 2018 found that price reductions outnumber price increases by 2-to-1 with 84% of products unchanged.

“To be clear, we see little risk to upcoming Coles and Woolworths results in August, but we think the path to significantly higher profitability which is built into the implied multiples of the supermarkets is less certain,” said the broker.

“Should price gaps expand to >15-20% we think the rate of market share gains for the discounters will accelerate, increasing the probability of price investment by the majors.”

Price investment means a price war. I would avoid supermarket stocks, including Metcash Limited (ASX: MTS), although the upcoming spin-off of Coles into a separate listed entity could give Wesfarmers an opportunity to outperform Woolworths later this calendar year.

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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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