Higher grocery prices will underpin stronger sales in Australian supermarkets in 2017 after the slowest industry growth in more than 20 years.
Grocery sales growth across the big supermarket chains is expected to accelerate in 2017 and 2018 as Woolworths and Coles put the brakes on aggressive discounting and suppliers seek to increase prices following gains in soft commodity prices.
Broker UBS expects supermarket sales to rise 3.2 per cent in 2017 and 3.7 per cent in 2018, compared with 2.8 per cent in 2016, the lowest rate of growth for more than 20 years.
Sales growth slowed to a crawl in the last month of 2016, with spending on groceries rising just 1 per cent in the four weeks ending December 31, according to Nielsen figures, as more shoppers sought out specials.
Nielsen director of retailer services Megan Treston said 40 per cent of grocery products purchased in December were bought on promotion and the size of the average shopping basket shrank as shoppers cut back on pantry staples.
While the $90 billion grocery market is expected to remain competitive, brokers believe an all-out price war between Woolworths, Coles, Aldi and Metcash is looking less likely.
UBS analyst Ben Gilbert believes the likelihood of a full-blown price war akin to that in Britain has fallen to about 15 per cent, pointing to the fact that Woolworths has invested $1 billion into reducing grocery prices over the last 18 months but the response from competitors (to date) has been rational.
"The market did not behave irrationally to increased investment by a leading player, which triggered price wars in the UK, Netherlands and France," Mr Gilbert said in a report published on Wednesday.
Citigroup head of research Craig Woolford agrees, saying: "We're not seeing any behaviour that signals a price war. Woolworths has reset its prices to be competitive with Coles rather than trying to undercut Coles."
Suppliers optimistic
Woolworths and Coles have both signalled a more rational approach to price investment in 2017, while suppliers are more optimistic that prices will rise after record food price deflation in 2016.
Prices for soft commodities such as sugar and wheat have risen in recent weeks and brokers expect grocery suppliers to try to raise prices after being forced to cut prices or absorb rising input costs over the last two years.
UBS expects Woolworths' price investment to return to "more normal" levels in 2017, unless Coles strikes back aggressively to regain sales growth momentum after falling behind Woolworths for the first time in seven years.
Macquarie Equities estimates Coles' food and liquor sales growth slowed to 1.3 per cent in the December quarter compared with 4.9 per cent in the year-ago period and 1.8 per cent in the September quarter.
Macquarie believes Woolworths' same-store food and liquor sales rose 1.7 per cent in the December quarter after falling 0.6 per cent in the same quarter 2016.
JP Morgan analyst Shaun Cousins believes Coles' same-store food and liquor sales growth slowed to 0.5 per cent in the December quarter while Woolworths' accelerated to 1.7 per cent and could reach 2 per cent in the March quarter.
As grocery prices stabilise or rise, consumers will pay more for their weekly grocery shopping but industry profitability will gradually improve after more than $1 billion was stripped from earnings in 2016.
Woolworths' food and liquor margins plunged from 8.1 per cent in 2015 to 5.2 per cent in 2016, reducing earnings by $1.2 billion, and are forecast to reach 4.5 per cent in 2017 before recovering to 5 per cent in 2018.
Coles' earnings rose just 4.3 per cent in 2016, the softest growth since Wesfarmers acquired the group for $20 billion in 2007, as margins stagnated.
Forecasts upgraded
UBS and JP Morgan have upgraded their recommendations and earnings forecasts for Woolworths in the last week, reinforcing the view that the worst is over for Australia's largest food and liquor retailer.
UBS now rates Woolworths a buy instead of a sell and has increased its 12-month price target from $19.10 to $27.30.
"We are becoming less negative on the Australian grocery market, as industry margins start to bottom and (suppliers) signal a more rational pricing backdrop," Mr Gilbert said.
"We believe industry profitability will begin to recover in 2018, underpinned by a rejuvenated, better capitalised market leader in Woolworths. This should, in our view, see Woolworths' sales and margins recover faster."
JP Morgan has raised its Woolworths recommendation from underweight to overweight and increased its price target from $22 to $28.
"A turnaround is underway in the Woolworths food business," Mr Cousins said, citing price reductions and better instore execution in areas such as staffing levels, shrinkage and on-shelf availability.
"Marketing and loyalty are no longer damaging the business and arguably, most importantly, there is evidence of cultural change," Mr Cousins said.
Woolworths shares rose 2 per cent on Wednesday to $25.09, taking gains so far this year to almost 4 per cent.
