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Coles' ASX debut: steady cash flows but rivals loom

Lex Hall  |  21 Nov 2018Text size  Decrease  Increase  |  
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Morningstar has assigned a fair value estimate of $13.30 to Coles as Australia's second-largest supermarket marks its ASX debut, breaking away from Wesfarmers, whose share price has plummeted on the separation.

Coles Group (ASX: COL) officially listed on the ASX at 11am on Wednesday, opening at $12.49, with a market capitalisation of $16.64 billion, ranking it just behind miner South32 (ASX: S32) and insurance giant Suncorp (ASX: SUN) in terms of size. At 1.15pm Sydney time, it was trading at $13.31.

The demerger forced a 28 per cent fall for Wesfarmers (ASX: WES), Australia's largest conglomerate, which acquired Coles in 2007 for $19 billion, freshening up the stores, expanding the network and boosting its online offerings.

Wesfarmers will retain a substantial 15 per cent holding in Coles. Each Wesfarmers shareholder will receive one Coles share for each Wesfarmers share.

coles ipo woolworths groceries

Australian grocers enjoy stronger population growth relative to other developed economies

In a pre-listing report, Morningstar analyst Johannes Faul set Coles a fair value estimate of $13.30 but stopped short of assigning the standalone retailer an economic moat – or sustainable competitive advantage – citing the growing threat of foreign raiders led by Aldi, Kaufland and AmazonFresh.

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However, Faul says steady cashflows and forecast strong population and consumption growth will help Coles' top line to increase by 3.4 per cent on average over the next decade.

"Australian grocers enjoy stronger population growth relative to many other developed economies," he says. "We expect this trend to continue over the next decade and provide Coles' supermarket, liquor and convenience stores a tailwind to the extent many global peers lack.”

Coles offers a 5.1 annualised dividend yield, fully franked with a payout ratio of up to 90 per cent. This is underpinned by a defensive income stream, which flows largely from consumer staples, which Faul says are relatively stable across the economic cycle.

Coles Group has a network of about 2500 store outlets and roughly 80 per cent of Australians live within a 10-minute drive from their nearest Coles.

Coles employs about 110,000 people, who process more than 20 million individual customer transactions a week. In comparison, Woolworths processes almost 30 million customer transactions a week from Australia's population of 25 million.

Faul expects the Australian population to grow at average rate of 1.5 per cent in the 11 years to fiscal 2030.

Competition intensifying

Coles supermarkets currently capture 29 per cent of Australian food and grocery retailing, compared with market leader Woolworths at 36 per cent, the IGA network at 13 per cent, and Germany's Aldi at 8 per cent.

American retailer Costco operates membership-only warehouses and has a market share of under 2 per cent.

But it is the Germans – Aldi and Kaufland – where Faul sees the chief threat.

Aldi Australia has 500 stores, which he expects will increase to 640 by 2021 – that's one store for every 31,000 Australians. Aldi also has lower costs of doing business than Coles, saving on labour costs and operating efficiencies.

However, when it comes to range of goods, Aldi is less of a threat. A typical Aldi has about 1400 products while a Coles or Woolworths supermarket has about 25,000.

Other raiders are on the horizon too, led by German hypermarket Kaufland, and US giant Amazon.

"Kaufland is bound to open its doors soon, which could put further pressure on Coles' supermarket sales growth and EBIT margins if its hypermarket format as a destination retailer resonates with Australians," Faul says.

"And Amazon could take a proper crack at the $100 billion-plus grocery sector by bringing AmazonFresh to Australian shores, though judging by overseas markets, this could be a decade away."

Solid management will mitigate other risks

Other key risks to note are operational in nature, namely technological threats, labour disputes, product-related reputational risk and supply-chain risk.

There are also strategic risks if Coles fails to keep an eye on online-centric retailers like Amazon. And with limited diversification, Coles' single focus on supermarkets, liquor, and convenience sectors heightens these risks, Faul says.

Despite this, he argues Coles management, led by managing director and chief executive Steven Cain, has the focus and systems in place to mitigate the risks appropriately.

Cain has more than 20 years' experience in Australian and international retail, which includes a stint as managing director of food, liquor and fuel at Coles Myer. He also led Coles during a rare period when it beat Woolworths’ sales growth.

Morningstar's FVE of $13.30 implies a 2018 EV/EBITDA ratio of 9, a PE ratio of 17.7.


Bulls say:

  • Market-leading position in supermarket, liquor and convenience sectors; reigns over difficult-to-replicate network, providing competitive edge over smaller rivals and new entrants
  • Coles and Woolworths dominate ecommerce food sales in Australia, alleviating the threat online-centric competitors pose to Coles' supermarkets business in the medium term
  • Shift to higher-margin fresh foods and private labels could boost growth and margins; fresh offerings bolster customer loyalty and drive new traffic

Bears say:

  • Coles could lose market share to new entrants like Kaufland and AmazonFresh or from existing rivals Aldi and Costco
  • Coles' strategy easily replicated by arch rival Woolworths. The two have history of mimicking each other’s initiatives
  • Fast-growing e-commerce contribution to incremental sales dilutes food EBIT margins
  • To remain competitive, Coles is likely to pass on any cost efficiencies to the consumer in form of better services or price cuts

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is senior editor for Morningstar Australia

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