Benefits Of Coles Online Move Uncertain

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Coles Group is implementing the Ocado online fulfilment platform over the next four years but brokers are unsure about the extent of the benefits.

-A technology deal that is four years in the making comes with some risk
-Lack of transparency around economics likely to mean investors discount the returns
-Capital expenditure is rising, signalling upside potential for the dividend is limited
 

By Eva Brocklehurst

Coles Group ((COL)) is transforming its online proposition, an initiative expected to double home delivery capacity and improve online profit margins. The company will implement the Ocado platform whereby efficiency gains are expected and wastage reduced.

The main issue brokers have is with the economics of the deal, with uncertainty surrounding whether the benefits offset ongoing fees. Coles has said the deal will be accretive to margins versus its current break-even position online. It will also be important to unlocking additional sales growth in metropolitan Melbourne and Sydney.

Morgans assesses that Ocado will be able to provide valuable expertise, given its sole focus is in the online area, and Coles will obtain greater range, improved product availability, freshness and more regular delivery windows.

Nevertheless, the broker acknowledges one of the main challenges with online sales is a higher cost to serve. Increasing network efficiency via larger truckloads and minimising the amount of driving will be key, in the broker's opinion.

Coles will gain access to Ocado's technology with respect to online ordering and fulfillment. Two automated customer fulfillment centres will open in Sydney and Melbourne by FY23 with $500-750m of sales capacity each. Coles will spend $130-150m over the four years to fit out the fulfillment centres.

Access to the online platform and last-mile technology will incur an ongoing fee, which UBS estimates at 3-4% of sales. The partnership echoes similar deals globally and the broker assesses it will de-risk Coles' longer-term online strategy.

Still, UBS has mixed views on the partnership. Locking in technology deals that are four years away in what is an ever-changing market comes with some risk. The broker remains positive about the grocery sector but believes Coles faces company-specific pressures and these will take time to address. It will also cost money.

Online Outlook

Consumers are demanding more convenience and this trend is likely to continue, so Morgans believes this is the right move for Coles. Given the fulfillment centres are not expected to be operational until the end of FY23, the broker maintains near-term estimates and increases outer year forecasts.

Macquarie welcomes the partnership because of changing shopping habits, although the competitive edge remains to be seen. The broker notes figures show the gap between intent to buy and the 4% of Australians that actually buy online is significant. Nevertheless, the rolling out of Amazon Fresh and the arrival of Kaufland and Costco's online offerings could spark further interest in online shopping for Australian consumers.

Citi expects Coles to generate a marginally profitable outcome on its delivered online orders with Ocado. Still, the lack of transparency around the economics of the partnership is likely to result in investors discounting the returns from this agreement. This is even if conservative assumptions place a return on investment well above the cost of capital.

Morgan Stanley points out profit margins for Coles online are currently zero. The company generates $1bn in online food sales, 70% delivered, which the broker foresees could increase to $2bn by FY23 and thereby represent an increase in penetration to around 6% from 3.2%.

Woolworths To Follow?

Coles has lagged Woolworths ((WOW)) in online business but four years is a long time, Deutsche Bank asserts. A number of service providers already have alternative technologies available and the broker would be surprised if Woolworths does not go down the automated fulfillment path at a similar pace to Coles.

The broker also points out that the importance of click & collect, increasing consumer appetite for on-demand delivery and a dispersed population outside of urban centres cannot be ignored. Deutsche Bank retains a preference for Woolworths given its strong sales momentum.

Credit Suisse points out the independent grocery sector will lose from this development. The broker's previous analysis has indicated that a -30% reduction in fulfillment centre costs at Ocado's UK facilities might be achievable with additional automation. Subsequent generations of the Ocado system have resulted in significant improvements in productivity.

Regardless, Ord Minnett comes back to the issue of the initiative being long-dated, which suggests that market share losses and a sub-optimal margin performance versus Woolworths will continue. The incremental sales target of $1bn, post the partnership, is not expected to be incremental. The broker suspects, rather, online will cannibalise existing store sales.

The broker also believes, as capital expenditure is rising, this signals that the upside potential for the dividend pay-out is limited. While the company has confirmed that there is no impact on the 80-90% pay-out ratio from capital expenditure this year, Macquarie agrees the market remains concerned about the prospect of a reduction to the pay-out ratio next year.

FNArena's database shows one Buy (Citi) rating, four Hold and three Sell for Coles. The consensus target is $11.93, indicating 0.9% upside to the last share price. The dividend yield on FY19 and FY20 forecasts is 3.2% and 4.7% respectively.

See also, Coles Unloads Risk With Pub Deal on March 6 2019.

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