Woolies maintains edge on Coles as foreign raiders loom

Woolworths continues to outperform its biggest rival Coles, delivering solid sales and flat margins ahead of expectations this reporting season.

While Morningstar director of equity research Johannes Faul expects Coles to mount an aggressive response to win back market share, by cutting-prices and striking technology partnerships to build out their online and distribution capabilities, he says the industry is wrestling with structural challenges.

Price competition from cut-price German grocer Aldi in the discounter channel and online from Amazon is forcing Australia's supermarket giants to compete more aggressively on price, impeding any meaningful margin improvement. Woolworths faces another German challenger in the form of hypermarket Kaufland.

Ultimately, Faul says investors are in for a fascinating period, as Woolworths (ASX: WOW) and Coles Group (ASX: COL) increase their focus and dependency on the supermarket segment, having exited from petrol retailing, hotels and in the case of Woolworths, soon liquor.

Both stocks still screen as expensive compared to Faul's fair value – Woolworths at a 46 per cent premium, and Coles at 16 per cent.

The Result: Woolworths lifts full-year profits on solid stronger second half

• Normalised revenue up 3.4pc to $59.98bn
• Profit from continuing operations up 7.2pc to $1.75bn
• Statutory profit up 56.1pc to $2.69bn
• Fully franked final dividend up seven cents to 57 cents.

Woolworths delivered a robust second-half performance, lifting full-year profit by 7.2 per cent to $1.75 billion.

The retail giant shook off a weak performance by Big W and its liquor division to lift normalised revenue by 3.4 per cent to $59.98 billion, with 3.1 per cent comparable sales growth at its flagship Australian food segment helped by 3.9 per cent growth in the second half.

The first eight weeks of fiscal-2020 have been even better at the company's 1,000-plus network of supermarkets, with Lion King Ooshies collectables helping to drive 7.5 per cent comparable sales growth.

Woolworths chief executive Brad Banducci said the Australian food segment had recovered well from a first-half hit from the removal of single-use plastic bags, volatile weather and the success of rival Coles' Little Shop collectables.

Reported earnings before interest and taxes (EBIT) margins in Australian Food were 19 basis points higher than Morningstar's 4.5 per cent estimate, as analysts had expected material wage increases from January to have a greater impact. However, EBIT margins were virtually flat on last year’s 4.7 per cent, despite the 3.1 per cent like-for-like sales growth.

Faul suggests material improvements in stock loss (like cashier errors, administrative error, theft damage prior to sale or good perishing) were a main driver for the improvement in EBIT margins to 4.7 per cent from a low of 4.5 per cent in fiscal 2017.

However, he says opportunities to improve margins this way have become scarcer and any significant margin expansion most likely depends and operating leverage from strong sales growth--a challenge given the competitive environment.

Online sales increased by nearly a third to $2.5 billion for the year to 30 June, driven by strong growth from WooliesX, CountdownX (Woolworths Group's online play in New Zealand) and Big W, while on-demand delivery increased to a total 736 sites across the supermarkets, BWS and Dan Murphy's stores.

Woolies also lifted its fully franked final dividend by seven cents to 57 cents, for a full-year payout of $1.02.

Analyst Outlook: Woolworths remains expensive amid slow growth

Faul says the key question for Woolworths is whether it can expand margins in 2020 despite near-term cost inflation in the core Australian food segment.

"We anticipate CEO Brad Banducci’s high-calibre team to successfully offset most of the lurking operational headwinds," he says.

"There are ample opportunities to counter the impacts of rising wages, higher depreciation and more dilutive online sales with lower stock loss, operating leverage from sales growth, and cost efficiencies from the ramp-up of the new distribution centre in Melbourne."

However, Faul says outside of management’s control are the actions of archrival Coles and discounter Aldi.

"Kaufland is another competitor knocking on Woolworths’ door, and we see price competition as the main battling ground in retailing commoditised products, like milk, bread and butter," he says.

Faul still forecasts price-cutting to gradually reduce margins to 4 per cent by 2023, although two years later than he previously estimated.

Following the result, Faul increase Woolworths’ fair value estimate by 4 per cent to $25.50, mainly due to the time value of money, but also a slightly better short-term earnings outlook than he had previously expected.

However, EBIT margins must increase to a whopping 6.8 per cent for Morningstar's fair value to reach $36.40 per share (the company's stock price at 29 August 2019).

Investors have been flocking to Woolworths this year, sending the company's stock price up 20 per cent to highs of $36.09 in mid-August. This is the stock's highest level since October 2014.

Faul expect Woolworths’ strong sales growth to slow materially for the remained of fiscal-2020, as he anticipates a competitive response to Woolworths’ momentum from rival Coles.

"Woolworths’ aspiration of growing food sales ahead of overall market growth would have to come, at least in some part, at the expense of Coles," he says.

"It’s an unlikely outcome for Coles to just give up, especially as it has increased its focus and dependency on its supermarket segment following the exit of the petrol retailing and hotels operations in fiscal 2018."

The Result: Coles emerges from a year of substantial change

• Total revenue down 1.7pc to $38.4bn
• Profit down 9.1pc to $1.43bn
• Fully franked final dividend of 24.0 cents plus a special dividend of 11.5 cents.

Coles has emerged from a very eventful fiscal 2019 with a strong balance sheet, a simplified portfolio following its demerger from Wesfarmers, and a partnership which Morningstar's Faul anticipates will strengthen its competitive footing.

Less than a year after the demerger, Coles’ balance sheet has already improved thanks to strong cash realisation of 110 per cent and the proceeds from the petrol and hotels deals.
The supermarket giant also surprised investors with a special dividend despite an 8.1 per cent fall in full-year earnings following its 2018 demerger.

"The many twists and turns since its listing in late November 2018 are reflected in a complex inaugural result," Faul says.

Retail earnings dropped to $1.32 billion as modest sales growth from supermarkets and liquor stacked up against falls from fuel and convenience, plus the costs of restructuring following November's spin-off and listing.

Statutory profit for the 12 months to 30 June, which included earnings from Kmart, Officeworks and Target prior to separation, dropped 9.1 per cent to $1.43 billion.

Online sales accounted for $1.1 billion, or 3.6 per cent, of total sales of 30.1 billion but generated almost no profit. Coles announced its online channel was profitable for the first time in fiscal 2019.

"It has been a year of substantial change for Coles following the successful demerger and ASX listing," Coles Group chief executive Steven Cain said.

"Consumer behaviours are changing faster than ever; we are heading into the most competitive period in Coles' history, and there are significant industry-wide cost headwinds."
Cain said he expected full-year 2020 earnings growth to remain subdued.

Analyst Outlook: Coles behind, but ready to get down to business

Coles continues to trail Woolworths in scale and negotiating power and has lost market share to the top dog in fiscal 2019.

"Despite growing total supermarket sales by 3.2 per cent, we estimate Coles lost 10 basis points of market share and accounted for 28.7 per cent of total Australian supermarket sales," Faul says.

The company also faces fierce competition from Aldi and the newly launched hypermarket Kaufland, which will initially open in Victoria and Queensland.

Beyond challenging store-based grocery sales, Faul says the rapid uptake in online grocery shopping is challenging Coles’ traditional business model.

"Its online sales grew by 30 per cent in fiscal 2019, over 10 times stronger than the in-store channel, albeit off a relatively low base. This transfer of sales between the two channels raises operational challenges and increasingly weighs on the profitability of overall grocery sales," he says.

But Faul says a strong balance sheet allows the group to significantly improve its supply chain and online capabilities over the next six years in partnership with Witron and Ocado.

Witron will develop two fully automated distribution centres for Coles, while Ocado has been brought on to install and maintain equipment within new automated customer fulfilment centres.

Coles is also is investing in reformatting about half of its existing stores into either Format A or Format C stores, higher- or lower-end formats, depending on turnover and catchment area.

Faul says this spending is needed for the company to successfully compete in the dynamic Australian grocery industry over the longer term. But he says any advantages could be short-lived.

"Service and convenience are also differentiating attributes, but any advantages are unlikely to be long-lasting, as many strategies can be adopted by competitors, which has been demonstrated time-and-again by Coles and Woolworths emulating their respective innovations," he says.