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Risk to supermarkets is rising but is Woolworths share price still a buy?

Supermarket stocks are getting a second wind since the outbreak of a dreaded second wave of COVID-19 cases, but Goldman Sachs is warning that risks are increasing.

The sombre forecast from the broker comes at a time when the Woolworths Group Ltd (ASX: WOW) share price is outperforming.

Shares in our largest supermarket chain rose around 3% since the start of calendar 2020 when the S&P/ASX 200 Index (Index:^AXJO) slumped 11%.

Woolies peers are doing even better. The Coles Group Ltd (ASX: COL) share price and Metcash Limited (ASX: MTS) share price rallied 14% and 10%, respectively, over the period.

Why FY21 won’t be as good for supermarkets

The sector may get a second tailwind as large parts of Victoria goes back into lockdown, triggering a new wave of panic grocery buying.

But Goldman doesn’t think the good times will last even. While FY20 proved to be an unexpected strong year for the sector, the broker believes growth in the current financial year will be constrained to 2.4%. This is well below the 10-year average of 3.8%.

“Prior to COVID-19, we forecast the supermarket sector to grow at 4.25% in FY20 and +4.5% beyond that, inclusive of ~1.5% space growth,” said Goldman.

“However, since then the industry outlook has drastically changed.”

Supermarket sales headwinds

The slowdown is driven by a few factors. Slower population growth due to the drop in net migration is one big factor. While international borders remain largely shut, migration won’t recover in any meaningful way until the second half of 2021.

While the first shutdown in March of the Australian economy provided a big boost to grocery sales, the trend is now reversing as restaurants in most states have reopened.

Notwithstanding the extra one-month lockdown of hot spot Victorian suburbs, supermarkets are unlikely to enjoy the same revenue boost as the first country-wide lockdown.

There are also growing doubts about food inflation. As things are starting to normalise, we might find that Australia has an oversupply of certain produce as exports aren’t recovering at the same pace.

Are ASX supermarket stocks worth buying?

The good news is that the outlook for supermarkets is still much better than many other sectors despite these revenue headwinds. But what it means is that management performance is shaping up to be a critical value driver for shareholders.

Another positive is that there’s scope to increase earnings before interest and tax (EBIT) margins, particularly for Metcash according to Goldman.

Margin expansion

“Despite the topline constraint, we expect the incumbents and MTS to be able to expand EBIT margins for the food and liquor segment in FY21 as FY20 included significant cost increases which is largely temporary,” said the broker.

 “The two-year EBIT margin expansion forecasts for both WOW (+20bps) and COL (+35bps) between FY19 and FY21 look reasonable given the circumstances.

“While risks are increasing for the sector, Staples retailing remains our preferred exposure.”

The broker is recommending Coles and Metcash as “buy” but Woolworths as “neutral”.

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Motley Fool contributor Brendon Lau owns shares of Woolworths Limited. The Motley Fool Australia owns shares of COLESGROUP DEF SET and Woolworths 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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