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Last November, 530,915 Australians became shareholders in Coles (COL), making it one of the most widely held stocks. While this number has now reduced a tad with shareholders exiting small parcels, it still has one of Australia’s most inverted registers with more than 90% of shareholders owning less than 5,000 shares and the top 0.2% of shareholders owning 60% of the shares on issue.
This is typical of newly demerged companies, but Coles isn’t your typical demerger. Normally, they are the unloved “problem division” that the parent company doesn’t know what to do with, starves of capital, and keeps under a pretty tight leash. This is one of the theories offered to explain why demerged companies have historically outperformed over the medium term. Think S32 from BHP, Orora from Amcor, Pendal from Westpac, BlueScope (eventually) from BHP, Dulux from Orica and Treasury Wine Estates from Fosters.
“Big isn’t always better” and a refreshed management team removed from the bureaucracy and constraints of “head office” is set free to thrive.
But Coles isn’t in this category. It has had access to almost 60% of Wesfarmers capital and been part of a conglomerate that operates with a culture of a thin head office and very autonomous business divisions.
And not all demergers have been successful – PaperlinX from Amcor and OneSteel (later called Arrium) from BHP readily come to mind – so it’s not a lay down misere.
Certainly, Coles has started trading like a typical demerger. It hit its high on the first day, and then eased back due to the overhang of stock. If it is to follow the classic demerger playbook, it will take another 3 or 4 months for the sellers to dry up.
So the question existing shareholders may be asking is whether it is too late to sell, and other investors, whether it is time to place Coles on the buy list? Let’s look at what Coles has to offer.
The biggest upside for investors in Coles is that, as a stock operating in the defensive consumer staples sector, it is relatively cheap. According to FN Arena, it is trading at a multiple of 18.3 times forecast FY19 earnings and 16.5 times forecast FY20 earnings. This compares to Woolworths, which is priced at a multiple of 21.9 times forecast FY19 earnings and 20.9 times FY20 earnings.
While the two businesses aren’t exactly the same (Woolworths includes the loss making BigW division and Coles is directly involved in petrol retailing and convenience stores), it’s a big difference. Most analysts agree that Woolworths should trade at a premium to Coles – the question is, “how much?”
Coles should pay an attractive dividend. Due to the timing of the demerger, investors will only receive about 7 months’ worth of earnings in FY19 meaning a total dividend of about 40c for the full year. This is forecast to increase to around 63c for the full year in FY20, placing Coles on prospective yield for FY20 of 5.1%.
In the sales war, Coles showed recently, through initiatives such as the miniatures campaign and better handling of the “plastic bag fiasco”, that it could beat Woolworths. Market whispers suggest that this has now reversed, with Woolworths expected to post same stores sales growth of about 3% in the December quarter compared to around 2% for Coles.
Strategically, many would look at the supermarket industry and say that there are enough headwinds – competition from discount supermarket operators such as Aldi, Costco and Kaufland; margin pressure from customers and suppliers; the threat of the Amazon juggernaut – to give this company the flick. And that’s without even considering the impact a refreshed Woolworths or IGA could make.
Some analysts suggest that price deflation of groceries has come to an end and that margins are starting to improve as the competition eases (or competitors price more rationally). But that remains to be seen, with recent history not particularly encouraging. Coles EBIT (earnings before interest and taxes) declined from $1,779m in FY16 to $1,522m in FY17 to $1,414m in FY18. At best, anaemic earnings growth is a more plausible scenario.
Coles is investing in its logistics and distribution capabilities, where it is arguably some way behind Woolworths. It plans to build two new automated warehouses over the next five years as part of a supply-chain overhaul which analysts say could cost more than $1 billion. The benefits will however take some time to flow through.
According to FNArena, the brokers see Coles as attractive on valuation grounds, but otherwise are relatively unenthusiastic. A defensive stock, good market position, strong cash flow, but with very limited earnings growth and increasing capital needs.
Of the 8 major brokers, 5 rate it a hold. There is 1 buy recommendation and 2 sell recommendations. The consensus target price is $13.02, a 5.7% premium to Friday’s closing price of $12.32. Individual recommendations are set out in the table.
My sense is that Coles will be a buy, but not yet. I can’t quite see the compelling reason to own the stock. Despite its premium, Woolworths is a safer option in this sector and will be supported in the short term by the prospects of a capital return (which could include an off-market share buyback).
Would I sell if I was a holder? Probably not at this level, given the discount to valuation and expectation that some of the stock overhang from the demerger will have cleared. Further, it is due to report shortly with the December half year financial result and quarterly sales performance expected on February 19. Buy around $11.00, sell around $13.00.