Company Reports

Coles Group's businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the five years to June 2028, we expect the dividend payout ratio to average over 80%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard & Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimize its store network.

We lift our fair value estimate on no-moat Coles by 3% to AUD 15.50, mostly reflecting the time value of money. Net profit after tax of AUD 1.1 billion comfortably beat our estimate by 5%. However, our earnings forecasts are largely unchanged. A challenging liquor retailing environment and higher interest expenses offset a slightly improved near-term outlook on supermarket earnings. We trim our fiscal 2025 and 2026 NPAT estimates by 3% and 1%, respectively.

The upcoming August 2024 reporting season will draw the line under a difficult year for Australian retailers in which they navigated soft demand and soaring labor costs. The combination results in a profit margin crunch and declining earnings for many retailers.

Australian shoppers are still hurting. The Australian Bureau of Statistics estimates total retailing sales increased by only 1% in the March quarter of 2024 compared with the previous corresponding period. At Coles, the pressure on household budgets is evident in the shift to better-value, private-label brands and subdued spending on liquor. Excluding tobacco, Coles’ total supermarket sales increased by 7% in the quarter, while sales of its exclusive brands increased by 9%. In the small liquor business, accounting for less than 10% of group earnings, sales declined by 2%. Third-quarter group sales are up 6% on the PCP, tracking our full-year sales growth estimate after adjusting for an additional trading week in the fourth quarter. Our fiscal 2024 earnings per share estimate of AUD 0.80 stands.

Talk of interest rate cuts and impending tax cuts is sparking a rally in consumer cyclicals. We agree these factors improve the near-term outlook for consumer spending, with cyclical retailers more exposed. We expect the combined impact of fiscal and monetary tailwinds to underpin mid-single-digit growth in total retailing sales in the medium term—compared with our estimate of only 2% growth in fiscal 2024. But underlying our near-term forecast is a significant divergence across categories, with sales in cyclicals virtually flat and defensives up 4%.

The value gap between Australia’s two largest supermarket operators has been dramatically closing over the space of a week, following their first-half fiscal 2024 results. However, both defensive plays screen as overvalued. We think the market underestimates the risk of relatively low-growth, defensive yield stocks like Coles and Woolworths derating, given higher prevailing interest rates.

Coles Group's businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the five years to June 2028, we expect the dividend payout ratio to average over 80%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard & Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimize its store network.

E-commerce platforms have been outperforming physical stores recently. Transaction data from National Australia Bank suggests online retail sales in October lifted 10% on last year, while total retail trade was up only 1%, as reported by the Australian Bureau of Statistics.

We maintain our fair value estimate of AUD 14.50 per share on no-moat Coles. With the revenue tailwind of food price inflation abating, the task of driving top-line sales growth in the Australian supermarket industry is now more reliant on food sales volumes.

We expect only modest discretionary goods sales growth in fiscal 2024, while interest rates stay high and household incomes struggle to keep up with inflation. With demand soft, discounts and promotions abound in discretionary retail, and with wages rising as well, earnings are under pressure. But for some, cost pressures are easing. Steep declines in global food commodity prices bode well for fast-food restaurants. Quick service restaurant operator no-moat Collins Foods and master franchisee narrow-moat Domino’s Pizza screen as undervalued.

We slightly increase our fair value estimate on no-moat Coles by 3% to AUD 14.50, mostly reflecting the time value of money. Our sales and earnings estimates remain largely unchanged following broadly in-line fiscal 2023 results. We expect soft earnings growth from ongoing operations in the near term due to weak volume growth, declining shelf price inflation, and labour costs rising ahead of sales growth—together resulting in operating deleverage. So far in fiscal 2024, volume growth has only been modestly positive. And in the June quarter of 2023, shelf price inflation continued to ease, to 5.8% from 6.2% in the March quarter of 2023. Nevertheless, Coles expects tailwinds to support its food and liquor sales in fiscal 2024, including above-average population growth, improved product availability, and a shift to more at-home meal preparation from eating out—a reversal of recent trends management is beginning to see.

No-moat Coles reported a solid interim result for fiscal 2023. We lift our fair value estimate by 3% to AUD 14 per share, mainly due to a slightly greater sales base. Our group EBIT margins forecast remains unchanged, averaging 5% over the next decade. Elevated food price inflation is proving to be longer lasting than we had previously expected, and we don’t expect recent price gains to materially deflate.

No-moat Coles announced the sale of its convenience business, Coles Express. The segment is a marginal contributor to group earnings, accounting for only 2% of group EBIT in fiscal 2022. While we had expected Express to recover from lower fuel volumes initially hit by lockdowns and later by rising fuel prices, the segment's importance to the group is low. We estimated the segment to account for a mere 6% of group operating earnings by fiscal 2024.

No-moat Coles beat our fiscal 2022 earnings estimate, mainly due to materially better-than-expected gross profit margins in its core supermarkets segment, which accounted for about 90% of group EBIT. EPS of AUD 0.79 was 10% ahead of our 0.72 estimate. We had expected Coles’ supermarkets EBIT margins to temporarily dip by about 40 basis point to 4.6% in fiscal 2022 due to rising COVID-19 costs and weaker sales resulting in operating deleverage. However, ongoing structural improvements in logistics and less shrinkage, as well as more efficient sourcing, drove gross margin expansion of some 40 basis points, which largely offset the material costs increases related to COVID-19. Supermarkets EBIT margins of 5.0% were only down 7 basis points, with supermarkets EBIT virtually flat at AUD 1.7 billion. Supermarkets sales of AUD 34.6 billion were up 2% and in line with our estimate. We estimate Coles lost market share, with Australia’s supermarket industry growing at 3% in fiscal 2022, according to the Australian Bureau of Statistics.

Coles businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the five years to June 2020, we expect the dividend payout ratio to average over 80%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard & Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimise its store network.

Coles businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the five years to June 2020, we expect the dividend payout ratio to average over 80%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard & Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimise its store network.

Coles businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the five years to June 2020, we expect the dividend payout ratio to average over 80%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard &Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimise its store network.

Coles businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the four years to June 2019, we expect the dividend payout ratio to average 85%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard &Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimise its store network.

Coles businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation averaging over 100% in the four years to June 2019, we expect the dividend payout ratio to average 85%. Coles' investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard &Poor's and Moody's. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimise its store network.

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.