Coles Wins The Battle, But The War?

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Coles has managed cost-of-living pressures better than its key rival and investment in efficiency adds up to more positive views. But margin pressure prevails.

-Coles performs better on margins than Woolworths supermarkets 
-Strong execution in the face of consumer pressure
-Investment in automated distribution a longer term positive
-Margin pressure remains, but analysts are positive

By Greg Peel

As is the case with rival Woolworths Group ((WOW)), Coles Group ((COL)) remains under a regulatory cloud until the ACCC issues its recommendations regarding supermarket behaviour in February. And as was the case with Woolworths, Coles’ September quarter revenues suffered from consumers trading down to better value in the face of cost-of-living pressures.

[No Quick Fix For Woolworths’ Margins; November 6; https://fnarena.com/index.php/2024/11/06/no-quick-fix-for-woolworths-margins/]

Coles reported a 3.5% increase year on year in September quarter sales, and like-for-like sales in food of 2.4%. This was a little below expectation and in line with Woolworths’ 2.3%. Liquor sales proved a drag, and a survey by Citi found Liquorland is underperforming Dan Murphy’s/BWS, while overall consumption is declining for health and financial reasons.

Like Woolworths, Coles pointed to consumers trading down, citing a larger focus on promotions and loyalty programs, increased popularity of own-brand, and strong growth in lower-margin eCommerce (click & collect). Coles’ eCommerce growth of 22.4% was slightly below Woolworths’ 23.6%, while higher-margin in-store sales grew 1.6% to Woolworths’ 0.7%.

It is notable that unlike Woolworths, Coles did not have a collectibles (such as Little Shop) promotion during the period.

One factor Coles pointed to that was not cited by its rival was an increase in cross-shopping consumers spreading their business across all of Coles, Woolworths and Aldi in a search for the best value. But most notably, despite equivalent trade-down from consumers, Coles made no mention of subsequent margin pressure that was highlighted by Woolworths and which had led to a profit warning beforehand.

Citi in particular was encouraged Coles didn’t detect a material change in consumer behaviour more recently and did not issue a downgrade.

Better Job

Importantly, notes UBS, Coles was able to manage the shift to value as consumers shopped more promotions, more private label and more online, all of which provide negative impacts to gross margin and cost-of-doing-business to sales.

Coles has managed these via: (1) a focus on promotional effectiveness (fewer, better executed, less disruption to stores); (2) greater in-store sales growth than its rival; (3) reduced stock loss (theft) from a year ago; (4) retail media growth; (5) distribution centre cost savings; and (6) the company’s “Simplify & Save to Invest” program which provided an inflation offset.

In Macquarie’s view, Coles will have greater protection directionally from margin pressures with the group having a lower earnings margin start point and several tailwinds to support margins in FY25, including stock loss, retail media and the Simplify & Save to Invest program.

Coles is navigating a challenging period for Australian supermarkets, managing government and regulatory scrutiny, deflation, and cost pressures effectively, Ord Minnett suggests. The group’s strategy to focus on its core food business while maintaining cost control is proving successful. Coles has not seen significant changes in consumer behaviour around promotions or promotional funding, and its promotional strategy is improving consumer value perceptions.

Woolworths’ price investment and margin commentary have not hindered Coles’ progress, Ord Minnett notes, as Coles’ sales growth in October outpaced Woolworths by 3.5% to 3.0%.

Jarden believes Coles is executing better and its focus on right product, right price, right time is serving the company well and resonating with consumers.

More Robots

Alongside the update, management announced the development of a new -$880m automated distribution centre in Victoria, which will be in addition to its recently completed ADCs in NSW and Queensland. The Victorian facility will have 15% more capacity than the existing ADCs and will service all stores in Victoria and Tasmania, resulting in full automation of the ADC network across the east coast once complete.

Based on the NSW and Queensland projects, Macquarie estimates there is a -1-3% headwind to earnings between FY27 and FY29 due to implementation costs, rolling off on completion. In the long term, Macquarie believes this will drive greater efficiency across the business once complete some time in FY29.

While the -$880m project cost is slightly higher than the -$750m Citi had expected, this broker still believes it’s worthwhile and expects some $100m of cost-of-goods-sold benefits to come through around FY31-32. Coles is clearly satisfied with the success of the first two ADCs, Citi suggests, providing more confidence in the near-term earnings outlook.

Citi expects the existing ADCs to deliver $105m of savings in FY25, with the full benefit of $140m expected in FY26.

FY25 is expected by Ord Minnett to be an important year for Coles, with the implementation of the NSW ADC (Witron) and Ocado customer fulfillment centre (CFC) projects, the benefits of which should be fully realised in FY26. Remaining theft normalisation is also expected to benefit FY26, hence the broker notes Coles will have considerable savings to invest for growth in FY26, supporting profit delivery and market share gains.

Margins Stll A Risk

In Morgans’ view, Coles is a well-managed business with defensive characteristics and strong market positions in both supermarkets and liquor. Yet, while management continues to execute well in relation to operating efficiency, product availability, and reducing loss, there is uncertainty on the margin outlook due to customers remaining highly value-conscious, the ongoing shift in the sales mix towards eCommerce, and political pressure to reduce prices.

Morgans therefore sees Coles’ current valuation as relatively full and retains a Hold rating.

Most brokers have lowered FY25 earnings forecasts, citing slower sales growth in both supermarkets and liquor, plus lower margins.

Tightly managed capex should reward shareholders with healthy free cash flow and dividends, Ord Minnett suggests. Beyond FY25, Coles has several earnings drivers in FY26, underpinning this broker’s confidence in earnings growth. The risk-reward is attractive to Ord Minnett, with Coles trading at a -16% discount to Woolworths. The broker has upgraded to Accumulate from Hold.

While lowering its profit forecasts, Bell Potter retains a Buy rating, seeing FY25 as a year of consolidation on a reported basis, but continuing to see Coles as providing an attractive earnings growth profile through to FY27 on an underlying basis. This prospect is driven by cumulative savings by FY27 through Simplify & Save to Invest, sustained benefit of lower theft rates, delivering targeted returns on its ADC and CFC capex, and expansion of the store network at the pace of population growth.

Macquarie retains Outperform, attracted to relative earnings certainty for Coles’ supermarkets despite weakness in liquor. This broker expects profitability to be supported by long-term investment into efficiency initiatives.

UBS cuts earnings forecasts but retains Buy due to supermarkets upside. Morgan Stanley retains an Equal-weight rating.

Citi continues to believe the benefits to gross profit margin from lower theft, Witron ADC, lower tobacco sales and retail media growth are being underestimated by consensus. Coles remains the broker’s top pick in supermarkets, hence Buy.

That leaves five Buy or equivalent ratings and two Hold for Coles among brokers monitored daily by FNArena, compared to one Buy and five Hold for Woolworths. On earnings forecasts cuts, the consensus target has fallen to $19.61 from $20.11.

Goldman Sachs retains Neutral, expecting strong supermarket execution from Coles into the December quarter and FY25 but noting competition is intensifying. Negative like-for-like liquor sales are also driving margin erosion. And the new Victorian ADC build will soften return on invested capital through to FY27. Goldman’s target falls to $18.50 from $19.10.

Coles is executing well, says Jarden. It is sticking to strategy and delivering a consistent message. This broker believes we may be nearing the end of the capex step-up, with the third ADC the last in the near term, and the growth of online is likely to mean a material lift in new stores/store refurbishments is looking unlikely.

In Jarden’s view, the key catalyst will be Coles’ ability to demonstrate sustained market share gains in a rational market and, as we enter the second half, the broker expects this to be challenging for Coles as Woolworths cycles easier comparables and consumers begin to focus less on price, as is being seen in the US/UK. If this does not eventuate, Jarden would look to become more positive on Coles, with risk to Woolworths.

For now, Jarden’s preference remains for Woolworths (Buy) over Coles (Neutral), owing to it being largely past the capex peak and having more longer-term profit upside. The broker acknowledges near-term execution risk remains as Coles realigns costs, promotions and loss-making units.

Jarden cuts its target for Coles to $16.90 from $17.10.

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