Social Isolation Has Its Costs For Coles

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An unwinding of grocery stockpiles could dent the stellar performance Coles experienced in the March quarter, while elevated costs impact on gross margins.

-Is the market prematurely pricing in a recovery?
-Online sales growth more disrupted for Coles
-Opportunity for high-margin private-label expansion
 

By Eva Brocklehurst

Substantial panic stocking of basic grocery items led Coles ((COL)) to a stellar performance in the March quarter but April has turned out to be far more volatile. The start to the June quarter has slowed significantly because of social isolation, reduced impulse buying and some unwinding of pantry stocks.

In fact, Macquarie wonders whether the market is prematurely pricing in a recovery before the recession has even started, albeit remains comfortable with a preference for providers of staple items.

Supermarket like-for-like sales growth average 3.6% in April, Morgan Stanley points out, which implies growth could have been negative in the last week. The broker admits anticipating elevated sales because of a lack of alternative food channels and not fully appreciating the partial offset from a lack of "occasion" shopping and de-stocking.

Nevertheless, the broker is reluctant to extrapolate this for the remainder of the June quarter. Citi, too, suspects sales growth will improve from the April exit rate given the Easter period was very weak because of the ban on social gatherings and de-stocking.

Macquarie still assesses supermarkets should capture a large portion of the food business as consumers remain at home, even as restrictions are relaxed, while bars and restaurants remain closed.

The maintenance of social distancing measures and an increased focus on value by consumers should result in a sustained shift in market share to supermarkets from food service venues, Credit Suisse agrees. Accelerated take-up of delivery options should also help the market share of major supermarkets.

Online sales were disrupted during the peak period of pantry stocking during the quarter and Coles has since doubled its online capacity, which the broker suspects could be a driver of market share gains in the medium term.

Online sales growth was 14% in the March quarter and Macquarie estimates Coles has been tracking at 3.5% of total sales online. Supplier feedback suggests penetration levels reached 8-9% during the quarter.

Morgan Stanley is concerned that Woolworths ((WOW)) was less disrupted and has realised its online advantage during this period. UBS concludes listed grocers should exit the pandemic in a structurally stronger position and, while Coles is executing well, favours Woolworths in the medium term, as it is better positioned longer term to monetise alternative profit streams.

Margins

Elevated costs are part and parcel of social distancing measures, expected to continue in the June quarter. This could counter the gross margin benefit of lower shrinkage rates in the June quarter on higher sales volumes.

Macquarie suspects so, noting demand has also shifted to some lower-margin categories such as simple baking goods because consumers have more time to make food themselves.

Morgans takes the opportunity to upgrade to Hold from Reduce and continues to believe this is a very defensive business with a good balance sheet. The main concern is the rise in costs and the trend towards bulk purchases, amid a significant deterioration in fuel volumes, all of which will have a negative impact on margins.

Consumers Seek Value

Moreover, Credit Suisse does not expect inflation, which spiked to 1.8% in the quarter, will increase at a sufficient enough rate to result in margin expansion in the June quarter and first half, as consumers remain increasingly intent on obtaining value.

Macquarie agrees there will be an increase in value-conscious consumers as unemployment rises and highlights Coles strategy of separating the premium and value consumer offerings, believing the gap will become even more relevant.

The broker considers the high-margin private-label offerings will derive an opportunity from the desire for value and forecasts comparable growth of 6.0% in the second half. The outlook for liquor sales is also robust as pubs remain closed, although continued clearance activity is expected to affect margins.

All up, Morgan Stanley assumes around 10% growth in costs in the second half and a 30 basis points EBIT margin expansion, with 9% like-for-like sales growth in the second half. Citi upgrades to Buy, also believing Coles is well placed and can deliver earnings growth of 24% in the second half, and margin expansion enabling 14% growth in gross profit.

Convenience

Meanwhile, the outlook for the convenience segment is consistent with the broader fuel businesses and Coles is guiding to an earnings (EBIT) loss in FY20. Coles Express has benefited from a superior grocery offering versus convenience peers but Macquarie expects this may be offset by weakness in fuel volumes.

Citi expects a gradual improvement in petrol volumes are social distancing restrictions ease. The broker calculates 60m litres/week is a break-even level which is unlikely to be reached until the second half of FY21.

FNArena's database has five Buy ratings and two Hold. The consensus target is $17.04, suggesting 8.6% upside to the last share price. Targets range from $15.00 (UBS) to $18.63 (Credit Suisse).

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