Coles. We all know it. Most of us probably even shop there. It has come under fierce competition in recent years and in November last year was spun out of Wesfarmers (WES).

Almost a year on, we take a look at how the retail giant has performed and what might lie ahead.

Before we get to that, here’s a quick summary of exactly what Coles does; the company sells various products, including fresh food, groceries, household goods, liquor, fuel and financial services through its store network and online platforms.

Coles operates through three divisions: Coles Supermarkets, Coles Liquor and Coles Convenience. Coles Supermarkets comprises the Coles supermarkets store network, the Coles Online supermarket offering and Coles Financial Services. Coles Liquor operates a range of liquor retailing formats encompassing three brands, such as Liquorland, First Choice Liquor and Vintage Cellars, as well as an online liquor retailing business. Coles Convenience segment sells Shell fuels and a range of products, such as groceries, snacks, drinks, gas bottles, firewood, and Shell oils and lubricants.

The recent numbers

It has been a big year for Coles and there is perhaps more to the story that just the raw numbers. Before we get to that story however, it is important to look at the data. The highlights and lowlights of the recent quarterly update were as follows;

Positive

• 48^th consecutive quarter of supermarket sales growth
• Total supermarket sales rose 1.6% to $7.7bn, with a net three new supermarkets and 10 refurbishments augmenting same-store sales growth
• Total sales rose 1.8% to $8.7bn, with liquor sales rising 3.5% as a strong performance by the First-Choice chain offset softer sales at Liquorland
• Online sales grew 23.5% helped by free delivery on large orders
• House brand sales grew 4.7%; new products including meat-free meat and a new marketing campaign helped boost sales
• Convenience/fuel sales rose 3.1%
• Fuel volumes improved for the first time in four years, rising 1.4% to 64.9m litres after falling 14.8% in the year-ago period
• Results beat analyst expectations, with the help of rising prices
• Same-store sales growth has accelerated in the December qtr and is heading back towards the 2.2% achieved in the June qtr

Negative

• Same-store sales rose at the slowest pace in 12 years
• LFL sales rose just 0.1% - after rising 2.2% in the June qtr and 5.1% in the Sept. qtr last year
• Whilst the broader grocery market is growing around 4% per year, Coles continues to lose market share after being outperformed by Woolworths for 11 of the past 12 quarters.

That the company endured its lowest quarterly sales result in 12 years is not necessarily the most important part of the story. With competition increasing (not only from Woolworths but also Aldi and new entrants like Lidl and Kaufland), analysts were anticipating that like-for-like sales could fall as much as 1.5%. Sales growth of 0.1% suddenly doesn’t look so bad. Price inflation was a tailwind, running at 1.4% in the September quarter of 2019 compared with 0.6% in 2018 and Coles used lots of promos to extend the sales growth streak to a 48^th quarter – but it got there nonetheless.

Encouragingly, a lot of that was driven by growth in own-brand products, where margins are higher. That category grew by 4.7% and this will likely remain a key plank to future growth. The penetration of own brands in supermarkets stands at 30%, within striking distance of Coles’ long-term target of 40%.

Other growth drivers for Coles will be the continued development of its convenience strategy. In May, the company announced that it would add 75 new products to its existing range and refurbish 100 supermarkets into the end of 2019 in order to catch up to Woolworths who have torched Coles in same-store sales growth for nine of the last 10 quarters. Coles also plans to convert about 200 Coles supermarkets to a new premium and convenience format and about 200 low-volume stores to a 'value' format.

THE NUMBERS - These are the numbers from our STOCK BOX.

Main observations:

• ROE is very strong, hovering around 25% - anything above 20% is very good.  
• Revenue growth is expected to dip next year and then return to growth in future periods.
• EPS is also expected to contract next year, followed by a return to growth thereafter. It is a good sign that EPS growth is expected to outpace revenue growth – it shows increasing efficiency.
• The stock is not cheap, at 22x 1-year forward earnings, but it is cheap compared to WOW at almost 27x.  
• The gross yield is 5.3%, which is good. The average for the ASX 200 is 4.5%
• The stock is covered by 13 brokers, most of which are HOLD (5) or SELLS (5). 3 have a BUY rating or better.  
• The stock is trading at a 14.2% premium to its intrinsic value
• COL is trading at a 5.1% discount the average target price of brokers surveyed by Thomson Reuters.

WHAT SORT OF INVESTMENT IS COL?

It is not easy putting COL into a single basket. Or even multiple baskets for that matter. If you buy it you are getting a relatively cheap (compared to its main competitor), relatively stable (48 qtrs of growth is amazing, no matter how you slice it) consumer staple – they are called staples for a reason. They tend to weather the cycle pretty well. You are also buying somewhat of a turnaround story - although it is a fair way down the road – as its investment back into stores is increased post the demerger from WES. Remember, WES didn’t spend a whole lot of money on Coles once they knew they were going to sell it. Finally, you are getting a solid dividend to hold it.

BROKER RECOMMENDATIONS

The brokers are not particularly excited about this one – at all. Macquarie is the most aggressive, at least in terms of price target, noting that the Sept quarter was not as bad as expected. Macquarie is mindful of rising costs and increased competitive pressures however. Ord Minnett is the most bearish, suggesting that second-quarter growth will remain subdued. UBS offers the most stinging assessment of the recent results, saying that price inflation returned (i.e. Coles and Woolies relaxed their price war), which means that real sales growth was actually negative and that Coles continued to lose share.

SHORT-TERM TECHNICAL VIEW

Despite the tough trading conditions for the Coles business, the share price has performed strongly since February. Off a low towards 1100c, the price has reached as high as 1550c and currently sits just below the 1500c level. The last couple of months have seen some consolidation and a base of support appears to have formed around the 1450c region. If this area holds as support it could provide a platform for the next leg higher.

SHORTING

The chart below is taken from the ShortMan website. The grey line is the share price, the blue line is the percentage shorted (left-hand scale). Short interest in COL has been very volatile. Right out of the gates, after being demerged from WES, short interest spiked to 2.5% - which is not overly significant but worth noting. Since March however, just as the share price has risen short interest has retreated and it currently sits at less than 1%. This is nothing to be concerned about.

CONCLUSION

We wanted so badly to like this one. We really did. But, objectively, we cannot rate it a BUY. Although trading at a discount to WES and having some positive aspects in its recent quarterly update, there are a couple of factors we simply can’t get past. Coles is still losing market share to WOW, at a time when competition between the two remains fierce and there are new entrants on the way. The recent results were the worst in 12 years. And, finally, the recent share price run means that the easy money has likely already been made. Any investment return from here will directly parallel the tough environment Coles is operating in – it will be a grind. If the share price was to pull back into the 1400c region, then we would be more inclined to take on the risk. As it stands however, we cannot be buyers. HOLD.