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Will a new era dawn for Coles?

Paul Rickard
Friday, February 22, 2019

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“It’s time for a new era at Coles”. That was the promise made by Coles CEO Stephen Cain as he delivered an uninspiring first half profit result for Coles on Tuesday.

Using the following chart, he pointed to Coles success in lifting earnings by 125% between 2009 and 2016.  Investment in management, stores and brand drove sales growth (red line) and with it, earnings growth. Since 2016, earnings growth has been in decline, mainly due to intense industry competition, but also because Coles sales performance has been ordinary (red line for comparable store sales growth).

Cain wants to turn Coles around and drive sales growth.

He says he will do this through a “strategic refresh”, which includes a “fresh tomorrow” strategy for supermarkets, making life easier for customers, executing faster, efficiency programs to simplify the business and offset inflation, investment in automation and digital, and “winning together” sustainably with supplier and communities.

But the market didn’t buy this (which to be honest, could have been a strategy for almost any company), and Coles shares have fallen by 9% from $12.59 to $11.37 since the result was announced.

The market didn’t like that earnings continued to fall in the half, down by 5.8% to $733m. Adding to this was news that Coles was beaten in the sales war by competitor Woolworths, reporting same store sales growth in the December quarter of 1.5% compared to Woolworth’s 2.7%. While Coles can boast that it has delivered 45 consecutive quarters of comparable sales growth, the only quarter it has beaten Woolworths was the September quarter this year when Woolworths got badly caught up in the plastic bag fiasco and Coles ran its “little creatures” promotion.

In supermarkets, the EBIT margin (earnings as a percentage of gross sales) declined by 0.12% from 3.8% to 3.7% as expense headwinds grew. The cost of doing business rose by 0.27% to 20.4%. Demonstrating that Woolworths has the lead not just in sales but how it manages its business and supply chain, it reported an EBIT margin for Australian food of 4.7%, an increase of 0.08%.

On the back of an improved margin and product mix, Coles liquor division grew EBIT by 7.0% to $85m. An upside for Coles going forward will be the new alliance agreement with Viva Energy (who supply petrol to the Coles branded service stations and Coles Express). Coles will no longer have direct exposure to retail fuel price movements but rather receive a commission on fuel volumes achieved. Coles is positioning Express to be Australia’s leading convenience retailer.

What do the brokers say

The major brokers had been a touch bullish on Coles, seeing it as undervalued compared to rival Woolworths. Following the somewhat disappointing result, most cut their target price and lowered their earnings forecasts for FY19 and FY20. The consensus target price slipped to $11.92, a 4.9% premium to Wednesday’s closing price of $11.37. Ord Minnett downgraded its rating from “hold” to “lighten”.

The following table from FN Arena show individual recommendations and target prices, with the latter ranging from a high of $13.40 (Citi) to a low of $10.84 (Credit Suisse).

The brokers have Coles trading on a multiple of 19.4 times FY19 earnings and 17.4 times FY20 earnings. Coles won’t be paying its maiden dividend until September 19, which will cover the period after the Wesfarmers demerger from 28 November 18 to 30 June 19. It is targeting a payout ratio of 80-90%. For the next full year (FY 20), the brokers forecast total dividends of 55.6c which puts Coles on a forecast yield of 4.9%.

Bottom line

I haven’t bought the story that Coles is the classic demerger story and that set free of “big brother” Wesfarmers, Stephen Cain and his team will magically work wonders (see http://www.switzer.com.au/the-experts/paul-rickard/would-you-buy-or-sell-coles-right-now/) . And I also can’t see a “new era dawning for Coles”. This is a super competitive industry, and with the discount supermarket operators (Aldi, Costco and Kaufland) aggressively expanding, life is going to remain pretty tough for both Woolworths and Coles. Growing sales, margin and earnings will be challenging.

But every stock has its price and Coles, at the right price, offers investors a high dividend yield with a relatively high degree of earnings certainty. Not quite an annuity, but close.

Buy at $11.00. Sell around $13.00. 

Published: Friday, February 22, 2019


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