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Morningstar | Coles Introduces Ambitious Midterm Cost-Out Programme. AUD 12.30 FVE Unchanged.

In large parts we agree with the frank outlook Coles’ management provided at the firm’s inaugural investor day on the challenges awaiting Australian grocery retailers in the near to medium term. Nevertheless, the market looked past those headwinds, welcoming the reiterated dividend payout policy and an ambitious cost-out target. We hadn’t expected a dividend cut and any efficiency gains are likely to be chewed up by cost inflation or passed on to consumers in the form of lower food prices.

At our unchanged AUD 12.30 fair value estimate, shares in Coles screen as expensive. However, to investors seeking exposure to the yield stocks in consumer staples, Coles offers better value relative to Woolworths.

No-moat-rated Coles and its peer, market-leader Woolworths, are confronted with a rapidly growing, barely profitable online channel. Coles’ online penetration sits at 3.5% and the dilutionary effect of these sales, whether click-and-collect or delivery, is starting to bite. Further, the disruption and subsequent reset of industry profitability brought upon by discounter Aldi’s success is unlikely to reverse. We expect Aldi to continue taking share until fiscal 2022 and growing in line with the market thereafter. Another German discount store, hypermarket Kaufland, is tipped to open its doors in early fiscal 2021. Together with Costco, we anticipate the threesome to predominately compete on price with Coles, Woolworths, and the independents for market share.

This strategy has been successful in Germany where discounters dominate the market, as well as in the U.K. where the big four supermarket chains’ sales growth is significantly underperforming Aldi and Kaufland stablemate Lidl. We expect the intense competitive environment together with the structural change in consumer habits towards less profitable online sales to weigh on Coles’ and Woolworths’ earnings.

The current share prices of Coles and particularly Woolworths underestimate these risks and imply expanding of EBIT margins. Conversely, under the current circumstances we view a return to duopoly-like margins is unlikely.

We forecast Coles to maintain it’s 29% market share in the Australian grocer sector, with Metcash’s IGA network the primary share donor to the discounters. Slightly better than our forecast, Coles’ management targets to grow sales at least in line with the market. We estimate the Australian food retailing market to grow at an average annual rate of 4% over the next decade. This translates to like-for-like brick and mortar sales growth of around 2% for Coles--too low to offset long term average wage, rent and energy cost inflation of closer to 3%. To protect operating profit margins Coles must take costs out of the business. The newly introduced Refresh Strategy involves exactly that, with an aspirational cost-cutting target of AUD 1 billion by 2023. We estimate this represents just over 10% of Coles’ fiscal 2019 cost of doing business, including logistic expenses and shrinkage. The prospect of a chunk of these potential saving dropping to the bottom line is very appealing--we estimate Coles’ pre-tax earnings at AUD 1.5 billion in fiscal 2023.

We expect Coles to successfully implement automation and state-of-the-art technology to reduce labour and increase safety, drive gains from more efficient product sourcing, and reduce stock loss. For instance, Coles reduced costs in its stores and supply chain by more than 15% and 20%, respectively, over the past decade. Over most of this period, the group’s profitability improved. Up until Woolworths engaged in significant price cutting to reinvigorate its top-line growth and recapture market share.

This time around, we don’t expect Coles cost-cutting efforts to lead to material improvements in its EBIT margins for two reasons: First, the market structure has evolved and because of the fierce competition, any improvements are likely to translate into price cuts to defend market share. Most cost-cutting measures are already being pursued or are easily duplicated by Woolworths and don’t present a sustainable competitive advantage. Second, we expect expenses relating to online sales to gradually increase. If online sales doubled to AUD 2 billion by fiscal 2023, and those sales were 300 basis points less profitable than in-store sales, we estimate the negative impact on operating profit at AUD 30 million.