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Morningstar | Coles Shares the Spoils of a Brave New Digital World with Ocado. FVE Unchanged at AUD 12.30

The partnership with online grocery sales specialist and service provider Ocado provides no-moat-rated Coles access to state-of-the-art end-to-end online technology and increases the pressure on Woolworths. However, Coles gives up some of its future online channel earnings in return and we surmise it must also deliver on growth and market share targets to remain Ocado’s exclusive partner in Australia. We expect any material operating margin improvements to be passed on to consumers to compete with peer Woolworths, but also the discounting channel, including Aldi. We maintain our AUD 12.30 fair value estimate on Coles and shares offer little margin of safety at current prices.

Coles follows in the footsteps of many other leading food retailers which entered into similar service agreements with Ocado over the past 18 months: Casino of France in November 2017, Sobeys of Canada in January 2018, ICA of Sweden in May 2018, and most notably, U.S. grocery giant Kroger also in May 2018. All are leading food retailers in their respective markets.

Besides the ongoing challenges from the structural change in the Australian grocery industry, mainly from the ongoing disruption from discounters, our key concern regarding the profitability of the supermarket industry in the medium term has been the margin-dilutive effect of online sales. The two big full-service supermarkets Coles and Woolworths both generate 3% of their sales online--either by delivering the basket, or customers picking up their click-and-collect shop themselves in-store. We estimate online sales generate close to zero profits for Australia’s two largest supermarket chains and hence dilute the positive EBIT margins achieved in their traditional brick-and-mortar stores. Like in many other countries, online is the fastest growing grocery retailing channel. As online sales become more widespread, we expect the dilutive effect of these sales to increasingly pressure EBIT margins.

We forecast Coles’ online sales penetration to increase rapidly to 6% by fiscal 2023, cannibalising the higher margins achieved from in-store sales, as we don’t expect increasing online spending to grow the overall pie of the Australian food market.

In this context, time is of the essence for Coles in addressing the negative impact online sales have on its profitability. The quickest route to build a leading, profitable online channel is to partner with a service provider like Ocado.

Every deal Ocado strikes has unique features, but we understand some key elements are similar. In exchange for Ocado’s investment in customer fulfilment centres, or CFCs, Coles pays upfront fees upon signing and during the four-year construction and development phase. Once up and running, fees are paid for access to Ocado’s technology, ongoing maintenance, and are linked to sales and the scale of Ocado’s infrastructure. The CFCs are modular in design and each of the two automated warehouses in Australia are expandable to AUD 500-750 million in sales. We estimate Coles’ online sales to double to AUD 2 billion by fiscal 2023, from around AUD 1 billion currently, and reach AUD 3 billion in sales or 7% online penetration in 10 years. In its partnership with Ocado, Coles trades off upfront capital spend against ongoing fees. Coles’ capital expenditure related to the deal of AUD 130-150 million over the next four years is immaterial, equating to about AUD 0.10 per share without considering the likely lower capital Coles will spend on the development of its current, proprietary online platform.

The Australian partnership is exclusive to Coles, but we suspect there are strings attached that are similar to those in Kroger’s deal to gain exclusive access to Ocado’s service platform in the U.S. For instance, if Kroger doesn’t commit to the target capacity, it must pay compensation to Ocado. Also, Kroger must meet market share targets in the longer term. These conditions make sense, as they protect Ocado in the event Kroger underperforms, and we suspect Coles will face similar requirements.

For now, the ball is back in Woolworths’ court to up the ante, which like Coles currently operates its own proprietary online platform. We expect a material step up in Coles’ offer to online customers from fiscal 2023, in terms of the available range and delivered quality of products, as well as improved convenience with faster delivery times and more time slots. Woolworths can’t risk being left behind. Therefore, we expect investments to be increasingly reallocated to developing its online business as the channel grows--taking funds away from its traditional brick-and-mortar network.

If Woolworths decides to continue with its current strategy, enhancing its own e-commerce platform within its Woolies X division, it is likely to endure higher capital spending than Coles. However, Woolworths would also reap all economic benefits and fully own and control its online technology. It is too early for us to tell which approach will result in greater profitability: lower capital expenditure but higher operating expenses in Coles’ case, or higher capital expenditure and depreciation, but no service fees to third parties in the case of Woolworths. However, the two most-immediate beneficiaries of the online grocery disruption are Ocado and the consumer.