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Morningstar | Coles' Toy Campaign Delivers Sales Growth but Doesn't Affect Our AUD 12.30 FVE

In the third quarter, no-moat-rated Coles’ second promotional campaign of small plastic toys during fiscal 2019 had the desired effect at its supermarkets. We increase our fiscal 2019 headline food sales growth rate following better-than-expected sales, boosted by the Stikeez campaign, to 3.1% from 2.6%. However, the impact on our intrinsic assessment is immaterial, and we maintain our fair estimate at AUD 12.30. At current prices, the shares are screening as slightly overvalued.

E-commerce remains by far the fastest-growing food retailing channel, growing at 27% in the quarter versus our unchanged full-year forecast of 30%. We expect relatively low-margin online sales to continue to grow more quickly than in-store sales and present an increasing headwind to operating profit margins for Coles and peer Woolworths. Online food sales are currently barely breaking even yet contribute over a third of the 2.6% like-for-like food sales growth we forecast in fiscal 2019. Accordingly, we estimate in-store like-for-like sales growth of less than 2%, which is unlikely to offset annual wage, rent, and energy cost growth of around 2.5% on our forecasts.

We suspect a similar view by management prompted the partnership with online grocery sales specialist and service provider Ocado, announced in March. The partnership provides Coles access to state-of-the-art end-to-end online technology and increases the pressure on the current online food channel leader, Woolworths. However, in exchange Coles gives up some of its future earnings to Ocado.

We anticipate increasing sales in higher-margin private-label product to assist Coles in maintaining EBIT margins at 3.9% in fiscal 2019. Food prices increased 0.9% due to higher pricing in fresh categories, but largely due to transitory factors. Fresh produce supply was hit by drought conditions in key growing areas and the cyclone in Queensland. Prices of meat and bakery products also inflated due to higher commodity prices.

Dry grocery prices deflated 0.9%, primarily driven by a greater offering of lower-cost private-label products, but also due to a mix shift in consumption towards nonbrand products. All up, Coles’ headline food sales grew 3.2% in the quarter, broadly in line with management’s estimate of overall Australian supermarket revenues growth.

In liquor, adjusted like-for-like sales grew 0.9% due to a sluggish Australian liquor market. We forecast 2.4% headline liquor sales in fiscal 2019. Nonetheless, we expect liquor sales growth to rebound to 4% over the following five years, fuelled by population growth and price inflation.

The convenience business continues to suffer from a decline in fuel sales, as motorists shied away from the premium fuel pricing at its pump. Viva Energy took the reins of the fuel retailing business on March 1 and has already lowered prices to win back market share. Our forecast EBIT for the convenience segment of AUD 50 million in fiscal 2024 hinges on Viva successfully increasing long-term fuel volumes to 75 million litres a week from just over 60 million litres currently. In convenience, like-for-like sales declined 0.5%, the second quarter of declining like-for-like sales growth in a row.