Jerónimo Martins, the Portuguese retail giant, is facing a storm. As food inflation rapidly recedes, a new and potentially more insidious specter looms: deflation. While analysts and investors have acknowledged the challenging environment, the company's Q1 2024 earnings call reveals a deeper, more unsettling reality – one that could have a ripple effect across the entire European food retail landscape.

Deflation, a persistent decrease in the general price level of goods and services, is often portrayed as a boon for consumers. After all, who doesn't love lower prices? However, for businesses, deflation can be a double-edged sword, especially in a highly competitive sector like food retail.

While Jerónimo Martins' banners delivered solid volume growth in Q1, CFO Ana Luisa Virginia highlighted a critical caveat – these numbers were propped up by a positive calendar effect, primarily driven by the Leap Year and earlier Easter. As we move into Q2 and beyond, these calendar tailwinds disappear, leaving the company exposed to the full force of the deflationary headwind.

Virginia's comments suggest a growing concern about the resilience of consumer demand. Despite significant increases in minimum wages in Poland, the company is not yet witnessing a corresponding pickup in consumer spending. This cautious behavior signals a possible disconnect between rising incomes and actual purchasing power, a phenomenon that could significantly dampen the anticipated volume growth in the coming quarters.

The competitive landscape is further exacerbating the deflationary threat. Virginia explicitly stated, "All players...will have to fight for sales. And this puts extra pressure on the margins, on the margins, and on the market." This intense price competition is not confined to Poland. As commodity prices, with the exception of sugar, have declined across the board in Q1, all Jerónimo Martins' banners are anticipating deflationary pressure throughout 2024.

This market dynamic presents a difficult dilemma for Jerónimo Martins. On the one hand, the company is committed to maintaining its price leadership position, a key element of its long-term strategy. On the other hand, aggressive price investments in a deflationary environment, coupled with rising cost inflation, primarily driven by wage increases and rent escalations, will inevitably squeeze margins.

While Virginia declined to provide specific guidance on future gross margins, her cautious tone suggests a growing apprehension about their sustainability. The question remains, how far is Jerónimo Martins willing to go in sacrificing margins to protect its market share?

Hypothetical Impact of Deflation on Biedronka's EBITDA Margin

To illustrate the potential impact of deflation, let's consider a hypothetical scenario. Assuming Biedronka, the company's flagship banner in Poland, maintains a 5% basket deflation throughout 2024, a 10% increase in operating expenses (driven by wages and rents), and flat volume growth (excluding calendar effects), we can estimate a potential EBITDA margin contraction of approximately 150 basis points.

This is a conservative estimate and does not factor in potential supplier support or further competitive price investments, both of which could exacerbate the margin pressure. While Jerónimo Martins boasts a strong balance sheet, this deflationary scenario could significantly impact profitability and erode shareholder returns.

The implications extend beyond Jerónimo Martins. The company's experience serves as a canary in the coal mine for the entire European food retail sector. As deflation takes hold, we can expect a wave of intensified price competition, placing significant pressure on margins and potentially leading to industry consolidation.

Investors and analysts would be wise to pay close attention to this emerging deflationary trend. The retail landscape is rapidly shifting, and those who fail to adapt may find themselves caught in the undertow. Jerónimo Martins, with its unwavering commitment to price leadership and its formidable market position, is well-equipped to weather the storm. However, the coming quarters will be a critical test of its resilience, and the outcome could have far-reaching consequences for the entire industry.

"Fun Fact: Did you know that Jerónimo Martins has a fascinating history dating back to 1792, starting as a small grocery store in Lisbon? It's a testament to the company's ability to adapt and thrive over centuries, navigating economic upheavals and evolving consumer trends. Today, it stands as a retail powerhouse with a global footprint, a legacy built on a foundation of value, innovation, and a deep understanding of its customers."