Increased spending by Woolworths has led to downgrades on the stocks of Australia’s two largest supermarket chains by a leading team of analysts.

Wesfarmers is “unlikely” to turn around the performance of its Coles unit because of increased spending by Woolworths, Merrill Lynch & Co. said in a note to clients, while Woolworths’ investment in their business is considered too high by the same team of analysts. As such, they downgraded Wesfarmers from “neutral” to “underperform” and Woolworths from “buy” to “neutral”.

Woolworths plans to spend $2 billion annually in a bid to continue to grow market share and convert stores to their new 2010c format, a move which had Merrill Lynch analysts suggesting they were spending too much. In comparison, Coles boss Ian McLeod plans to spend around $1 billion annually for five years to complete the Coles turnaround.

“In our view, the Australian retail industry isn’t large enough to justify the levels of capital that Woolworths is planning to spend,” David Errington said in the Merrill Lynch report. “Given the planned actions of a major competitor that could, in our view, prove detrimental to industry returns, we think a Coles turnaround is unlikely.”

Woolworths is, of course, in such a strong position because of continued investment in building their business and a detraction in spending to hand out more to their shareholders would differ from their long-term strategy, which has undoubtedly delivered generous returns to long-term investors.

The Merrill opinion on Coles is in stark contrast to one recently outlined by Citi Investment Research, who believe that the growth rate at Coles could eclipse that of Woolworths as early as next year.

To put that into context, the comparative store sales growth recorded at Coles was 1.3 per cent as opposed to 6 per cent at Woolworths in the first quarter. In the second quarter of the current financial year, Coles managed to make some inroads, with growth of 3.8 per cent compared to 7.1 per cent.

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