Investors are questioning the supermarkets' $8b spending spree

Sue Mitchell
Mar 11, 2019
AFR

Coles, Woolworths and Metcash will spend $8 billion over the next three years refurbishing stores, building new stores and distribution centres and improving digital capabilities to keep up with changing consumer trends and become more efficient ahead of a new wave of competition.
Investors in the supermarket chains say the added capital expenditure is needed to protect market share from Aldi, Kaufland and Amazon and restore margins, which have fallen over the past few years as the major chains have cut prices to compete with Aldi.
However, there are rising concerns the grocers will not make satisfactory returns on their investments as competition intensifies, and instead of the gains flowing to shareholders they will go to shoppers in the form of lower prices and better service.
As Woolworths’ capex bill dips back to $1.6 billion a year after the completion of its new automated distribution centre, Coles and Metcash are ramping up investment. Eamon Gallagher
Woolworths is in the third and final year of an elevated capital expenditure program, during which time it has spent between $1.7 billion and $1.85 billon a year building an automated distribution centre, refurbishing scores of stores and strengthening its online and digital offerings.
As Woolworths’ capex dips back to an estimated $1.6 billion next year, Coles is ramping up capex to about $900 million a year, from about $750 million a year (before proceeds from property sales) over the past few years, to build two automated distribution centres and refresh stores that have not been refurbished for about 10 years.
At the same time, Metcash plans to lift capex from about $60 million a year to $120 million annually for the next three to five years in an attempt to increase the market share of independent food, liquor and hardware retailers amid increasing competition from Aldi and newcomer Kaufland.
Announcing plans to spend $300 million on additional growth capex over the next five years, on top of maintenance capex of $300 million, Metcash chief executive Jeff Adams said last week the wholesaler’s IGA network was under pressure after years of under-investment.
“It is a business that had been challenged and lacked investment over a number of years –.as a result of that, it’s really fallen behind global trends,” he said, pointing to growing consumer demand for convenience and fresh foods.
Habits evolving
Coles managing director Steven Cain said the food and liquor retailer needed a “reset” and a step change in productivity to achieve sustainable growth and address the headwinds facing the company, including rising costs and increased competition.
“Customer shopping habits are evolving and so are we,” Mr Cain told investors after announcing the step-up in capex last month.
Most of Coles’ extra capex ($950 million over six years) will be invested in two distribution centres, but the retailer is also refurbishing stores to carry a wider range of prepared meals and building small-format convenience stores which will sell mainly fresh food including chilled ready-to-eat meals, pre-cut produce and coffee, catering to growing consumer demand for convenience and smaller, more frequent shopping trips.
Bennelong Australian Equity Partners investment director Julian Beaumont said the lift in capex was evidence of step change in competition. “It’s mostly just capex to stay competitive or to get a lead before competitors then catch up again,” he said.
“Competition has stepped up in recent years and is unlikely to let up soon – not least with Kaufland starting up – [so] it is unlikely that the industry profit pool increases materially.
“To the extent one’s stores look better, or their costs are reduced through the supply chain, it doesn’t necessarily make customers spend more. But it can give one player a period of time when they take more from the profit pool at the expense of others.”
Retailers are bracing for the impact of Kaufland, which on Friday unveiled plans to build a $450 million, 110,000-square-metre automated warehouse – almost twice as big as those being built by Woolworths and Coles. The scale of the warehouse suggests Kaufland’s ambitions are much bigger than expected.
“These are all big businesses so they do need to spend a large amount of capex, both for maintenance – which should probably be around the same as the amount of depreciation they charge to the profit and loss – but also for growth,” said Alphinity Investment Management portfolio manager Bruce Smith.
“Some of the capex is also defensive: if they don’t do it people will increasingly shop in stores that have spent, or will choose retailers with better offers, nicer stores or more convenience, like Amazon.
“The big question, however, is whether they will get a decent return on that capex – will it be limited to what they currently expect or will it blow out, as often happens with big multi-year projects like this,” he said. “Then once it is finished in several years’ time, whether the benefits they end up getting will be as big as they presently expect.”
Strategy reset
Nikko Asset Management analyst Craig Young is comfortable with Woolworths’ and Coles’ capex, saying supermarkets generate high returns on capital so can afford to spend more than depreciation to maintain or grow profits.
“The capex isn’t useless; it is being spent to gain efficiency so it is worth it,” Mr Young said. The capex would also help Woolworths and Coles reduce supply-chain costs and improve margins, which had fallen as Coles and Woolworths had cut prices to neutralise Aldi, he said.
However, he is less confident about Metcash’s capex program, which includes about $100 million over five years to accelerate supermarket refurbishments, $10 million to test small-format convenience stores, $25 million on logistics and $30 million on systems including a new loyalty program and promotional platforms.
“Metcash I am not as sure on, as I am not convinced they have neutralised prices,” said Mr Young.
DNR capital fund manager Chris Tynan says returns on capital for Australian supermarkets are likely to be “materially” lower than they were in the past.
“With Coles and Metcash entering a period of elevated investment, we view this more as catch-up capex from under-investment over the past five years, so it remains to be seen if these programs will meet their cost of capital,” Mr Tynan said.
“Woolworths is now benefiting from the investment program undertaken following their strategy reset,” he said. “Whilst the other supermarket chains’ capital constraints may result in more rational pricing, much of the benefit will be reinvested in price and service to maintain market share.”
Citigroup analyst Bryan Raymond says higher capex will drive depreciation in coming years, impacting profitability for both Coles and Woolworths.
“This will impact Woolworths sooner, [because it] is ahead of Coles in their reinvestment cycle,” he said.
Analysts also say the extra capex will reduce retailers’ free cashflow and the likelihood of capital management beyond current dividend payout policies.