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Why UBS rates Metcash a buy over Woolworths and Coles

There’s some good news for the supermarket sector. The outlook for the industry is brighter even as dark clouds form over the broader economy.

The latest survey by UBS suggested that grocery prices are going up and that’s a positive for sales growth for ASX listed grocery companies.

The news hasn’t yet excited the market with the Woolworths Group Ltd (ASX: WOW) share price, Coles Group Ltd (ASX: COL) share price and Metcash Limited (ASX: MTS) share price dipping between 0.2% to 0.4% in after lunch trade.

Meanwhile, the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index has clawed back from morning losses to trade at breakeven.

Positive outlook for supermarket profits

The underperforming sector may yet win back investors as the positive sales outlook stands in sharp contrast with many other sectors which are buffeted by the threat of an economic slowdown.

The grocery price outlook is a rare bright spot for investors with UBS expecting most of the benefits from the return of price inflation will benefit supermarkets more so than suppliers.

“Suppliers were less confident in benefiting from inflation given the growing prevalence of requests for price mitigation,” said the broker.

“This should benefit the listed supermarkets, with suppliers of the view that WOW has the best strategy to win share, both overall and online.”

Other key findings for the supermarket sector

Some of the other key findings from the annual UBS survey of fast-moving consumer goods (FMCG) suppliers are:

  • Prices of fresh and dry goods are expected to increase around 2% over the next year
  • The impact of discounters like Aldi is not worsening with 14% of suppliers seeing a large negative impact. This is the same percentage from last year and a big drop from 40% in FY17.
  • Supermarkets are squeezing more from suppliers in terms of price creep, price mitigation and payment terms.
  • The arrival of another German discount chain Kaufland is seen as a small risk and UBS thinks the new entrant will act rationally.

The best supermarket stock to own

While Woolworths looks to be well placed to benefit from rising grocery prices, UBS prefers grocery distributor Metcash as it sees the stock as having “the best near-term exposure to inflation”. The broker has a “buy” recommendation on the stock with a price target of $3.15 a share.

Woolworths only gets a “neutral” rating even though supplier feedback is consistently positive on our largest supermarket chain. This is because of its high 23-time price-earnings multiple, which implies that the good news is already priced into the stock.

This leaves Coles and the stock is the least liked of the bunch by UBS as the broker thinks its at risk of a consensus earnings downgrade as it has been unable to maintain like-for-like sales growth in real terms since the end of its Little Shop promotion.

UBS has a “sell” on Coles with a price target of $11.30 a share.

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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 COLESGROUP DEF SET. 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.