The grocery industry is at an inflection point, as October 2021 represents the first stage of the vaccination-driven reopening of the economy. As lockdown beneficiaries, the reopening phase of the economy is typically considered to be a headwind to sales and earnings. We highlight several reasons why we think this normalisation process will take longer than expected to play out, resulting in upside risk to earnings. We also look at the US and UK reopening experience for grocery retailers. With this report we transfer coverage of Woolworths, Coles and Metcash to Bryan Raymond from Jason Steed.

 7 key themes will drive the medium-term outlook. The ripple effects of COVID are likely to extend well beyond lockdowns, as we identify the 7 key factors which will determine the outlook for grocery sales and margins, including migration, online, work from home and supply chain impacts. We do not expect sales and earnings to normalise in the near term and see upside risk to industry growth.

 US and UK grocery experience supportive. Australia’s delayed vaccine roll-out enables us to look three to six months into the future to determine how consumers and investors have reacted to reopenings. To date, US and UK grocers have seen FY22/23 earnings upgrades and PE multiple expansion as favourable trends persist.

 Capital intensity rising, yet to meaningfully impact multiples. Capex continues to rise for Woolworths and Coles as they build out supply chain, digital and data capabilities. We estimate capex to sales will be over 3% for the next three years for both Woolworths and Coles. In contrast, Metcash has not stepped up capex in its Food pillar, but is seeing capex rise as they invest in hardware JV stores.

 Woolworths our preference over Coles; Metcash an OW. Following a transfer of coverage we have Overweight ratings on Woolworths ($42.60 target price) and Metcash ($4.50 target price), as we are 5% and 3% ahead of consensus FY23 EPS respectively. Our Neutral rating on Coles ($17.00 target price) reflects LFL sales growth underperformance and margin contraction as they ramp up investment.