Coles And The Continuous Turnaround

This story features WESFARMERS LIMITED, and other companies. For more info SHARE ANALYSIS: WES

By Chris Shaw

Wesfarmers ((WES)) reported June quarter sales results for its retail businesses yesterday, delivering quarterly and like-for-like sales growth of 4.2%. This means the result was better than that achieved by rival Woolworths ((WOW)) for the same period, that company delivering total sales growth of 2.8% and like-for-like growth of 1.8%.

Driving the result was the Coles business, with Credit Suisse analysts pointing out Office Supplies delivered a solid performance but both Target and Kmart disappointed given the cycling of high base numbers and deflation in imported goods.

But the focus was really the performance of Coles, Credit Suisse noting a high level of store closures over the past few years and refurbishment activity at remaining stores has improved the overall store portfolio.

At the same time the company has been aggressive in re-positioning on its quality and price offerings, with an increasing proportion of fresh sales. Credit Suisse suggests these changes are delivering above industry sales growth.

With a return to positive space growth expected next year and ongoing store refurbishments, Credit Suisse sees Coles continuing to deliver above industry sales growth in 2011. JP Morgan also remains positive on the outlook at Coles, as it sees scope for margins to expand in coming years as performance continues to improve and as working capital is reduced.

One issue for Australian food retailers in general, states JP Morgan, is low rates of food inflation, though the broker suggests Wesfarmers is best placed to deal with this given it has a lower sales base and a currently more inefficient cost structure than major competitor Woolworths.

With packaged grocery deflation so significant in the quarter compared to the same period last year, Macquarie notes this presents some challenges for the company. In the broker's view, Coles has engineered price deflation to some extent by making price the major focus of its merchandise offer.

What this means is average basket size is down around 13%, as the group's offers bring in new customers but only to shop the store for specials. This means while average weekly transactions are increasing, sales volumes are increasing by a smaller amount.

Macquarie points out this is not entirely a bad thing, as it gives management at Coles the opportunity to turn these new customers being attracted into its store into bigger basket customers.

The other issue in Citi's view is sales productivity, as on this measure Coles still trails Woolworths by a fair margin. Coles delivered sales per square metre growth of 5% in FY10, but this is 21% below that being achieved by Woolworths in the Food and Liquor sectors.

In Citi's view, this gap can be narrowed to around 10% by FY13 through further store refurbishments and decisions on product range. This will be crucial as Citi estimates every 1% improvement in sales growth at Coles adds 1.9% to earnings before interest and tax growth.

Changes are also underway at Kmart, where unprofitable categories are being removed and price points lowered. This is something of a high risk strategy in Citi's view, as there is also the chance competitors retaliate to such an approach. As Kmart delivered a disappointing sales result for the period, Citi suggests the strategy cannot be confirmed to be working at this stage.

Post the June quarter sales results brokers have generally made only minor changes to earnings estimates for Wesfarmers, with for example UBS lifting its earnings estimates by 0.7% this year and 0.3% in FY11. Average earnings per share (EPS) estimates according to the FNArena database stand at 140.4c this year and 199.1c in FY11.

The earnings changes have flowed through to changes in price targets, the FNArena database showing an average target now of $33.11, up from $32.79 previously. Only Credit Suisse has adjusted its rating, upgrading Wesfarmers to Neutral from Underperform on the expectation ongoing outperformance from Coles will offer good support to the share price.

Overall, the FNArena database shows Wesfarmers is rated as Buy five times, Accumulate once, Hold three times and Sell once. Shares in Wesfarmers today are higher and as at 12.00pm the stock was up 39c at $30.47.

This compares to a trading range over the past year of $23.60 to $33.21 and implies upside of around 6% to the average price target in the database.

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