Tread carefully with Coles shares

The release of Coles’ first-quarter earnings for fiscal 2019, including a 5.8 per cent increase in sales, has demonstrated impeccable timing.

The strong result was tempting for shareholders, an invitation to get in on the ground floor of the new resurgent demerged company. Just a few days later, they received a package from Wesfarmers explaining the plan to demerge Coles’ food and liquor businesses in
a float on the Australian Stock Exchange.

However, as the saying goes, one swallow does not a summer make, and shareholders and potential new investors should take a sober look at the prospects of the new food and liquor entity over the longer term.

The 5.8 per cent sales increase to $7.66 billion was remarkable given the difficulty Coles has had in generating anywhere near half of that growth figure in recent years.

For the four quarters in FY18, Coles managed 0.3 per cent growth in the first quarter, 1.3 per cent in the second, 0.9 per cent in the third and 1.8 per cent in the fourth.

The latest sales figure is unlikely to be matched for the rest of the year. It could become a high-water mark that the new entity struggles to hold, let alone better, in the comparable quarter next year.

In fact, it will be interesting to see in coming weeks where Coles’ first-quarter sales came from. Did the spike result from market share capture from Woolworths, IGA and Aldi? Or did customers buy more and fill the pantry up, meaning that – save for out-of-date items – they won’t need to buy quite so much in the current quarter?

Wesfarmers CEO Rob Scott said in releasing the first-quarter results that the retailer had achieved strong growth in basket size, transaction numbers and units sold.

Much of the growth was attributed to the extraordinary success of the Little Shop promotion, which arguably would not be as successful a second time around. Likewise, while it might be possible for Coles to create a new crowd-pleasing promotion, it would be unwise to bank on it.

Scott said the results also reflected improved in-store execution and investment in flybuys promotions, and demonstrated the ability of the Coles team to continue to focus on performance while preparations continued for the shareholder vote on the demerger on November 15.

Competitors are circling

Whether Coles is able to maintain its sales momentum depends on several factors beyond a successful store promotion, including profit gains, given market competition, wage cost increases and the likelihood of higher prices resulting from drought conditions.

Competition is a key challenge, with the German discounter Kaufland currently chasing sites for large-footprint stores and Costco and Aldi continuing to expand their store networks.

Coles’ headline sales result in the first quarter was commendable, but liquor sales rose just 1.3 per cent in the three months and the convenience store and fuel business sales declined by 14.8 per cent in the same period.

Wesfarmers claims to have made significant gains in its liquor division, but its growth still lags well behind Woolworths Endeavour Drinks business, which is effectively three times the size of the Coles liquor business and last financial year posted a 4.5 per cent lift in revenues.

On a more promising note, Coles Online is expected to pass the $1 billion mark in annual sales this financial year. The demerger of Coles is certain to be approved by shareholders in November, but investors should be mindful of the challenges for the new entity, which include the need for significant new capital expenditure in stores.

Investors might also consider Scott’s comments in the scheme booklet for the demerger of Coles, which point out that the retail business accounts for 62 per cent of capital employed but only generates one-third of Wesfarmers’ earnings.

Scott makes no bones of the fact that, despite maintaining a 15 per cent shareholding in the new entity when it floats, Wesfarmers is demerging Coles food and liquor because it believes it can achieve higher sales and earnings growth in other investments. The share price for the new Coles entity is yet to be determined.

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