Australia | Nov 27 2018
Is newly-listed Coles the way to access the defensive grocery industry or will an under-investment in labour and ranges put pressure on earnings margins?
-New distribution centres likely to drag on the balance sheet
-Material opportunity to grow earnings online
-Convenience store earnings challenged as fuel volumes declined
By Eva Brocklehurst
Brokers are having a bet every which way with newly-listed Coles ((COL)). The stock is trading on a deferred settlement basis and already there is a range of recommendations.
UBS initiates coverage with a Sell rating, believing Coles is a good business but faces a number of near-term issues. Sales growth has moderated after the Little Shop campaign, while there are cost pressures from underlying wage inflation and a need to lift staffing.
Citi believes Coles is a cheaper avenue to access the defensive earnings stream of a rational, albeit competitive, grocery industry. The broker calculates the stock is trading on an attractive multiple and expects the gap to Woolworths ((WOW)) to narrow over the next five years. Citi initiates coverage with a Buy rating.
The FNArena database has two Sell, three Hold and one Buy (Citi). The consensus target is $12.99 and targets range from $11.90 (UBS) to $14.70 (Citi). Goldman Sachs, not one of the eight monitored daily on the database also initiates with a Buy rating and $14.80 target.
Goldman Sachs forecasts an operating earnings (EBIT) growth rate out to FY21 of 7.1% which compares with Woolworths at 5.2%. Coles is the second largest supermarket retailer in Australia with an estimated market share of 29% across food and liquor. Woolworths has 39%.
The broker expects the supermarket sector to improve modestly over the medium term across fresh, online and convenience outlets and increases industry sales growth expectations to 4.25% in FY19 from 4.0%, and to 4.5% in FY20 from 4.0%. This reflects expected improvement in trends around inflation and some shift in promotional intensity from the major supermarkets.
Morgans considers the business defensive, with well-known brands and good market positions. The size of Coles lends itself to scale and efficiency benefits not available to smaller operators. Still the competitive environment remains intense and the broker suspects this will translate to modest earnings growth, forecasting an average of 4.4% between FY18-21.
Macquarie also expects Coles to appeal to defensive investors but suspects returns on the new distribution centres will drag on the balance sheet over the next five years, although for the longer term this is an appropriate use of capital.
UBS believes the risk is to the downside as the new CEO does not yet have full control of the strategy or numbers, underpinned by the fact that his long-term incentives do not get priced in until the day after the first half result.
Food industry growth should accelerate over the next three years, UBS concurs, yet does not believe Coles can grow food margins sustainably because of its under-investment in labour and because ranges may need to increase, putting pressure on costs. The broker also suspects prices have begun to exceed Woolworths, which will need to be rectified as consumers begin to notice.
Coles has de-merged with a strong balance sheet and, while taking issue with the provisioning of costs associated with the new distribution centres, UBS remains positive about that investment.
Citi also acknowledges the need to reinvest in grocery and expects capital expenditure per square metre to increase by 19% in FY19 and a further 12% in FY20. Still, the broker expects the reinvestment to be gradual and rational.
Credit Suisse cautions against over exuberance with respect to profit margins, expecting growing discounter competition will keep margins relatively flat. While the broker accepts that Coles would have been able to fund itself independently over the past 18 years, an 80% pay-out ratio would have only been achievable during a period of lower-than-historical capital expenditure. Hence, downside risk is envisaged for the dividend pay-out ratio.
The convenience market is challenged, with UBS estimating a -36% decline in first half convenience operating earnings. Morgans is also concerned about convenience, as fuel volumes are under pressure.
Convenience earnings are affected by high oil prices and a weaker Australian dollar. Fuel like-for-like volumes fell -15.9% in the first quarter. The broker forecasts convenience earnings to be down -17% with further downside risks if difficult trading conditions persist.
Citi agrees the petrol business is currently uncompetitive on price and expects volume declines to continue. Still convenience represents just 7% of FY19 operating earnings and 4% of the enterprise value and the broker considers the earnings risk less meaningful overall.
In the long-term competition is still expected to increase, driven by Amazon online and Kaufland. Credit Suisse believes the opening of Costco online first quarter of 2019 has potential to increase transparency of discounted grocery prices and therefore price competition across the market. Kaufland will open its first store in 2019.
Coles has flagged fresh food as a strategic priority. Fresh category sales have increased to 45% from 41% in FY12. Private label sales have also increased, to 29% from 26%. Coles has a target for private-label penetration of 40% of total food sales within five years, although this does not include fresh and areas of future growth such as food-to-go.
Goldman Sachs suggests the footprint is a modest disadvantage for Coles, as it is 20% below that of Woolworths. Still, while disadvantaged in the short term this also means there are opportunities for growth for Coles across new channels.
See also, Sales Growth Likely to Slow For Coles on October 16, 2018.
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