Is Coles Building A Moat Or Playing Catch-Up?

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Short-term pains are expected to help set Coles up for long-term gains, but some brokers question whether a major lift in capex is too little too late to play catch-up with Woolworths

-Coles' capex to refocus more on growth less on maintenance, new stores & renewals
-Benefits from new automated DCs to commence from FY25
-Normalising consumer behaviour to drive medium-term upside

By Mark Story

To avoid the risk of being left behind in the supermarkets stakes, Coles Group's ((COL)) management recently flagged that they’re putting what CEO Steven Cain euphemistically referred to as the ‘foot down on the accelerator’. The market is encouraged that Coles is finally trying to catch up after a period of underinvestment relative to Woolworths.

For example, Coles' capex (capital expenditure) to sales pre-covid ratio of 2% compares with Woolworths 3.2%.

While Woolworths has had a relatively consistent reinvestment rate of 45-50%, Coles dropped its reinvestment rate in FY20.

At its recent startegy day update, Coles outlined the key initiatives to drive longer term growth through increased investment in areas such as data, e-commerce, technology, automation, range, stores and sustainability. While no trading update was provided, management noted the normalisation in consumer behaviour witnessed in early fourth quarter 2021 has continued.

Equally encouragingly, Coles' market share improved to 26.7% in April as structural shifts unwound.

Product range was also a key focus, with stores to offer a more tailored range to suit local tastes. Currently, around 27% of stores are tailored and the company is on track to tailor 40% of stores by FY23.

Supporting the range will be ongoing expansion of the Own Brand portfolio that allows Coles to differentiate through exclusive products. The compnay also plans to accelerate investment in Coles Local and Liquorland renewals, and new store rollouts with a focus on high-quality locations and formats.

Management noted that its Smarter Selling cost-out program is on track to deliver $1bn savings by FY23. Coles is also on track to deliver $550m-plus cumulative benefits by FY21, with a further $200m of benefits expected in FY22.

Due to the increased investment, management has forecast FY22 capex to rise to $1.4bn versus $1.1bn in FY21, while in FY22 depreciation and amortisation (D&A) is also expected to increase to $1.67bn-1.72bn.

In addition to increased capex, depreciation was impacted by the Witron Queensland site being recognised on the balance sheet as a right-of-use asset. Depreciation will be further impacted in FY23 as both Witron and Ocado assets begin to depreciate.

Unlike in years past, Coles has suggested that the company’s capex profile in FY22 is expected to be more focused on growth and efficiency and less on maintenance and new stores/renewals. Overall, Coles plans to increase its technology spend in FY22 to 1.9x of FY18.

Despite the increased medium term capex profile, management reiterated its 80-90% dividend payout policy.

Negative hit to near-term earnings

But the decision to increase capital investment by 30% next year by around $400m to $1.4bn has raised shareholder and broker concerns alike, and together with an increase in guidance for D&A expense has led some brokers’ to lower FY22-23 earnings forecasts.

Brokers recall that during its 2019 strategy day, Coles indicated capex was not expected to exceed $1.0bn annually in peak years of supply chain modernisation (FY21/22). By comparison, capex guidance in FY22 of $1.4bn, implies 57% growth on FY19 and 68% on FY20.

Citi’s earnings forecasts are largely unchanged in FY24 and FY25 as one-off costs roll-off, efficiencies are realised and reinvestment in the customer begins to deliver better sales growth. But Citi has downgraded earnings by -4% in FY22 and -8% in FY23, as the broker factors in higher D&A and a step-up in supply chain implementation opex (operating expenditure) in FY23.

After factoring in a step up in capex, guidance around higher D&A charges and additional costs around supply chain opex of $75m in FY22 and $160m in FY23, Citi has downgraded its Coles recommendation to Neutral from Buy and lowered to target price to $17.20 from $18.00.

Despite higher reinvestment, Credit Suisse, like Citi, has not materially changed the broker’s outer year earnings forecasts. The broker has downgraded Coles to Neutral from Outperform, with the target price falling to $17.16 from $18.19.

However, Credit Suisse is less concerned about higher opex, with the broker attributing lower FY22-23 earnings forecasts almost entirely to increased guidance for D&A expense in FY22.

Positive future returns

While Morgans expect Coles' increased investment to be negative for near-term earnings, the broker expects longer-term benefits to be positive. Morgans assumes minimal revenue benefits in the short term, but decreases FY22 and FY23 earnings by -6% and -7% respectively, largely on the back of updated D&A forecasts.

While near-term capex will be elevated, Morgans expects this to be supported by the strong balance sheet with first half 2021 net cash at $38m (ex-leases).

Macquarie also reminds investors that the world has changed significantly post-covid, with Coles' balance sheet now in much better shape. Despite being ahead of expectations, the broker expects the $1.4bn capex guidance for FY22 to generate a positive return on capital.

Around $290m of the capex will be allocated to two automated distribution centres (built by German group Witron) in FY22, which will represent peak-year spend.

Macquarie expects bottom-line benefits from the two Witron DCs to commence from FY25, while benefits from the two Ocado Customer Fulfilment Centres are to be realised earlier from FY24. The key advantages of Witron, notes Macquarie, include double the volume with half the footprint of a traditional DC, which incur two-thirds of the operating costs required of a standard site.

While Macquarie has lowered the target price by -4.9% to $17.30 to reflect Coles new capex, D&A guidance and technology investments, the broker retains an Outperform rating. Macquarie sees medium-term upside driven by normalising consumer behaviour, comparable sales gap narrowing, improving mobility supporting Express and an attractive valuation at 21x versus Woolworths 27x.

Is Coles playing catch-up or just differentiating?

Overall, Jarden did not come away from Coles recent update any more confident in the ability of Ocado to be a game-changer, with little new detail provided. Jarden believes directing circa 60% of capex to growth in FY22 and beyond is the right move for Coles.

But the broker is unsure exactly how this will put Coles in a clear 'winning' position, given it remains three years behind Woolworths. The broker retains a Neutral rating and notes, while valuation looks attractive, there are no immediate catalysts.

The challenge for Jarden is it remains unclear how much is catch-up versus differentiation, and believes more investment is needed to broaden Coles' ability to capture a larger share of wallet, leveraging high brand trust and customer reach.

Despite concerns around the increased capex profile, Morgan Stanley believes Coles is oversold and is currently at a peak discount to Woolworths and the market. While increased D&A is also the key driver of Morgan Stanley’s -5% FY22 earnings downgrade, the broker maintains an Overweight rating (target price $19.00).

Morgan Stanley believes Australian supermarkets are favourably poised given internal and exogenous drivers of operating leverage, and believes Coles has the most defensive earnings mix in the light of covid across the broker’s coverage.

Morgan Stanley notes, a lower PE multiple and a higher payout ratio provides Coles with a more attractive yield profile versus Woolworths.

The consensus target combining seven brokers on the FNArena database currently stands at $17.49, but Ord Minnett and Morgan Stanley are yet to respond to Coles' update.

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