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Morningstar | Coles Pulls Emergency Cord on Petrol Business and Enters New Deal With Viva Energy. FVE down 8%.

Coles is effectively exiting its petrol business, following Woolworths’ footsteps after several years of challenging operating conditions. But the impact of the rapid decline on the convenience segment’s profitability has been much more pronounced than we had expected. We’ve significantly lowered our estimates for the convenience segment, now accounting for some 3% of group EBIT from around 10% on our previous estimate. Our fair value estimate on Coles declines by 8% to AUD 12.30 per share. At current prices, shares screen as fairly valued.

Fuel volumes at Coles’ petrol stations have been falling consistently over recent years, as the Group passed on to its customers the higher purchasing costs for fuel supplied by Viva Energy. This resulted in relatively high fuel prices at Coles’ pumps in an intensely competitive market environment and drove customers away in scores. Like-for-like fuel sales declined by 16% and 18% in fiscal years 2017 and 2018, and were down another 17% in the first half of fiscal 2019. Management has now pulled the pin on fuel retailing, as it expects the Convenience segment to barely break even in the second half of 2019 with further declines in fuel volumes and operating losses likely in the absence of better commercial terms.

For the past two years, Coles had been negotiating for better commercial terms with Viva Energy to improve its fuel pricing and stabilize fuel volumes. Now the two partners have concluded their talks with a New Alliance agreement taking effect in early March 2019. Under the new agreement Coles ceases to set fuel prices and instead receives a commission on fuel sales on a per liter basis and is de facto no longer a fuel retailer. Coles maintains operatorship of the petrol sites, including its convenience stores. Like with the petrol deal Woolworths reached with British EG Group in November 2018, customers will be able to redeem fuel discount dockets and earn flybuys points on fuel and merchandise.

Viva Energy now has a clear incentive to maximize fuel sales, which we expect to lift traffic at Coles’ convenience stores. We forecast an increase in Convenience operating earnings from around break-even currently, to AUD 30 million in operating profits in fiscal 2020, and AUD 50 million by fiscal 2024. To reach an EBIT of AUD 50 million, fuel volumes must recover to around 75 million liters per week, up some 20% from the current 62 million liters, but a level the network only recently averaged in the first half of fiscal 2018. We expect Viva Energy to predominantly regain material market share by dropping retail prices and then gradually building volumes as more customers return over the medium term.

On a comparable basis, we had previously forecast the Convenience segment, including fuel retailing, to generate EBIT of AUD 176 million in fiscal 2019 and AUD 190 million in 2024. The cut to our estimates is only marginally offset by the one off of payment of AUD 137 million Coles is due to receive from Viva Energy for foregone fuel margin and amendments to the agreement.

Our previous estimates hinged on the premise that growth in relatively higher-margin in-store sales would offset the decline in sales in lower-margin fuel retailing. However, at current fuel volumes, in-store sales revenues and fuel commission only just offset the segments fixed and operating cost base. Ignoring the reallocation of intersegment transfers of AUD 30 million annually, our estimates for Coles’ other businesses are unchanged. We expect supermarket sales to increase by 2.6% in fiscal 2019, impacted by price competition from fast-growing discounter Aldi and Amazon’s newly introduced Pantry category, while we expect liquor sales to grow by 3.8% over the period.