Tuesday, November 27th, 2018
Coles Group is back on the ASX for the first time since 2007, when Wesfarmers acquired it, and Wesfarmers shareholders will be wondering what to do with their new Coles shares. Many Coles shareholders will also own Woolworths shares, raising the question of whether to own both or if not which one.
Both stocks have a role in conservative portfolios as long as they do not become overvalued. We prefer Woolworths the business for its wider profit margins, lower gearing, more developed strategy, greater progress towards optimising its supermarket operations and more efficient supply chain. Woolworths also has surplus franking credits and is set to receive $1.7 billion from selling its fuel business in early 2019, most or all of which will be returned to shareholders. These advantages are reflected in market pricing: Woolies trades on 22 times earnings while Coles finished its first listed week on 17 times. Both stocks are fairly priced for the moment.
But we expect Coles will catch up in coming years if management executes well. Demerged companies tend to perform well as investments because their businesses finally receive enough board and management time, capital and growth ambition after languishing as non-core or discontinued inside the former parent company. Since Wesfarmers announced in March it would divest Coles, the WA-based conglomerate has prepared for life as a more growth-focused group. Coles has probably been kept in maintenance mode and not given quite enough capital to update its stores and supply chain infrastructure. Some Coles supermarkets look like they were last refurbished in the 1990s, whereas Woolworths is well on the way to updating all its existing stores to a modern, fresh look which is attracting more customers. To stay competitive Coles has a substantial burden of capital expenditure ahead and this will weigh on dividend growth. We have some doubts Coles’ 80 per cent dividend payout ratio policy is sustainable and would be more comfortable with a range of 60-80 per cent.
Food retail contributes over 80 per cent of Coles earnings, so the stock is almost a pure play. Revenue growth is likely to match the sector’s low single-digit revenue growth. Liquorland has a solid market position with adjacency to Coles supermarkets, so convenience will drive performance in liquor. We expect flat profit margins near-term with only incremental longer-term upside given some of the efficiency gains from consolidating distribution centres and cost savings at the store level will be competed away. Coles has advantages over independents in scale and vertical integration so ongoing market share gains are likely. Assuming consistent execution, Coles could grow earnings at low to mid-single digit.
The public listing of Coles makes the food & liquor sector more attractive to investors by deterring price wars and stabilising margins and returns on equity. The shareholders of public companies expect their boards and management teams to deliver consistent and improving returns. They do not want volatile returns from loss-leading price discounting, which also wouldn’t deliver permanent market share gains given Woolworths and Aldi would respond.
The prominence of both listed firms increases the pressure on them to price competitively but rationally (at a profit). Coles joins the ASX as its 20th largest stock by market capitalisation and Woolworths is in the top 10, so both stocks will be in most large pooled superannuation funds and also many self-managed funds. Both groups have an important role in growing Australians’ retirement assets and providing rising franked dividend income to all investors but especially those depending on investment income to fund their retirements.
We do not rate Costco and Kaufland as significant competitive threats because they will have relatively few stores nationally. We also see online grocery ordering and delivery as a longer-term story. It will take time for supermarket chains to make online food retail profitable enough to be worth scaling, and the chains will not want to cannibalise sales through their physical stores.
Now Woolworths has divested its fuel business but kept fuel discounts for supermarket shoppers, it no longer seems necessary for Coles to stay in fuel retailing. Investors will prefer Coles focus on bolstering its competitive position and margins in food. The current fuel marketing agreement with Viva Energy expires in 2024. We would view a Woolworths-style divestment and capital return as a positive.
Originally published in The Australian on Tuesday 29th November 2018.