Outlook For Separated Coles Not Without Risk

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Coles remains intent on maintaining its competitive position after the de-merger from Wesfarmers, although brokers point out stable or improving margins are implicit in guidance.

-Acceleration of sales growth likely for Coles from the fourth quarter of FY18
-A de-merged Coles likely to be more capital intensive
-Is the market underestimating returns from Wesfarmers' industrial businesses?

By Eva Brocklehurst

The separation and listing of Coles by Wesfarmers ((WES)) on the ASX is taking shape and while brokers observe the supermarket chain has increased momentum recently, the outlook for a separately managed business is not without risks.

The Coles scheme booklet has arrived. A shareholder vote will occur on November 15 and Wesfarmers will retain 15% of Coles and 50% of Flybuys, the latter to improve leverage from combined data, digital and loyalty initiatives.

Guidance for a Coles pay-out ratio of 80-90% suggests to Credit Suisse an appropriate focus on cash rather than growth. Still, stable or improving margins are implicit in this guidance. Wesfarmers has indicated that $28m in costs will be allocated to Coles, while cost growth has been just 2% since FY16.

Morgan Stanley suggests little has changed with the pricing strategy, with Coles intent on maintaining a competitive position more focus on lower prices, fewer deep promotions and more private-label offerings.

The report on first quarter sales for Coles is scheduled for October 15 and, while an acceleration of sales growth is likely from the fourth quarter of FY18, Deutsche Bank's channel checks indicate this new found momentum could be shortlived and will be tough to cycle.

Coles generated a 3.9% operating earnings (EBIT) margin in FY18 and is 80 basis points below Woolworths ((WOW)) on a like-for-like basis. Convenience stores drove over half of the decline in earnings in FY18, Citi observes, primarily as a result of a wholesale supply agreement with Viva Energy Group ((VEA)).

The broker suggests the outlook is tough for convenience stores, given the rising cost of petrol and subsequent impact on demand for premium fuels and in-store purchases. The flexibility to reinvest in price, service and network is likely to be limited because of lower-than-expected cash conversion, and Citi suggests a significant supply chain investment over the next five years will also be a hindrance.

Morgan Stanley values Coles on an FY19 operating earnings multiple of 10.9x, which compares with Woolworths at 13.7x. The broker argues that Coles should trade at a substantial discount to Woolworths for several reasons. Woolworths' food business growth is likely to be outstripping Coles, despite a first quarter that is likely to be stronger for the latter.

Woolworths is also around 30% larger than Coles and accrues scale benefits as a result, while Dan Murphy's is considered a superior liquor business. Coles is also less diversified and Woolworths earnings have a loss-making segment (Big W) which inflates its PE multiple.

Automated Warehouses

While the capital expenditure disclosure is limited, Ord Minnett's analysis indicates Coles could fund growth capital expenditure of up to $1bn and still reduce net debt. Two automated warehouses are to be developed over five years, in partnership with Witron. The first centre is to be opened in 2022 (Queensland) in the second in 2023 (NSW).

Guidance is for net capital expenditure of $600-800m in FY19 and Credit Suisse suggests around $900m of gross expenditure per annum would be required on an ongoing basis. Provisions of $130-150m that are to be taken in FY19 appear to comprehensively support the exit of leases and redundancy costs.

A de-merged Coles is likely to be more capital intensive, Citi agrees, because of the investment in the supply chain, although the supermarket is likely to remain rational because of the constraints of the pay-out ratio and the less appealing cash conversion.

Deutsche Bank agrees operating cash conversion is unlikely to be as strong as previously indicated but there should be sufficient free cash to fund the dividend. The broker expects only a small amount of the expenditure on the supply chain will be incurred in FY19 and capital expenditure will lift from FY20.

Macquarie points out Woolworths is also building a new fully automated distribution centre in Melbourne, expected to be operating in 2019. This centre will have the capacity to service more than the Woolworths Brisbane and Sydney distribution centres combined.

Post Coles

A combination of improving momentum at Coles and consistent strength at Bunnings are underpinning sentiment on Wesfarmers stock, Shaw and Partners observes. This is unlikely to change until the new Wesfarmers emerges and the de-merger is executed.

For this reason the broker, not one of the eight monitored daily on the FNArena database, does not move to a Sell rating and sticks with Hold. The price target is $52. The case for how Wesfarmers will subsequently perform can be made either way, the broker contends.

There is some speculation that the new Wesfarmers, with Bunnings at over 50% of the entity, may have to contend with a slowdown in growth relating to housing, but then this has always been the risk and, to date, Shaw and Partners believes the company has managed the prospect well.

Credit Suisse believes the market is underestimating the potential for returns in the high teens on investments in the company's existing industrials business. Wesfarmers has indicated it will retain the flexibility to invest in opportunities and create value when such openings arise.

Ord Minnett points out Bunnings faces tough comparables and a tough external environment but expects a moderation in growth rather than a fall in earnings. Department stores are performing better-than-expected and a significant earnings recovery in the second half is expected for Target. The broker envisages lower capital expenditure and an improved business mix as well as the prospect of capital management post the de-merger of Coles.

There are five Hold ratings and two Sell for Wesfarmers on FNArena's database. The consensus target is $48.25, suggesting -1.9% downside to the last share price. The dividend yield on FY19 and FY20 forecasts is 4.7% and 4.8% respectively.

See also, Will Wesfarmers Be Stronger Without Coles? on July 25, 2018.

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