A solid, defensive business
We see Coles Group (COL) as a defensive business with well-known brands, good market positions and strong cash flow generation. Industry dynamics are solid with grocery and liquor sales growing consistently over the past 30 years despite numerous economic downturns during that period. Coles is the second largest grocery retailer in Australia with approximately 31% market share and also has a sizeable liquor and convenience network.
The size of the business lends itself to scale and efficiency benefits that are not available to smaller operators which, in our view, is a key competitive advantage. The competitive environment however remains intense, which we think will translate to modest medium-term earnings growth.
Overall, we forecast EBIT to grow on average by 4.4% per annum between FY18-21 and EBIT margin to increase by 20bps to 3.8% over the same period.
Supermarkets the key driver of earnings
The Supermarkets segment is the key driver of earnings, representing 80% of EBIT in FY18. After a strong start to FY19 (1Q19 like-for-like sales +5.1%), mainly on the back of the highly successful 'Coles Little Shop' campaign, management noted at the recent AGM that growth post Little Shop has moderated to levels in line with 4Q18 (like-for-like sales +1.8%). We expect growth to remain broadly at these levels for the remainder of the half before increasing slightly in 2H19.
Overall, we forecast FY19 like-for-like sales growth of 2.9% and Supermarket EBIT to be up 7% to A$1,253m.
Convenience remains a concern
Convenience EBIT fell 30% in FY18 and with high oil prices and a weaker AUD/USD the business continues to be negatively impacted by lower volumes. Fuel like-for-like volumes fell 15.9% in 1Q19 and with changes to the commercial terms of the Alliance with Viva Energy unlikely (in our view) to be resolved in the short term another fall in divisional earnings in FY19 is likely.
We forecast Convenience FY19 EBIT to be down 17% but see downside risks if difficult trading conditions persist.
While we see Coles Group (COL) as a solid business, the competitive environment remains tough and fuel volumes remain under a lot of pressure. With COL trading on 17.5x FY19F PE and 2.7% yield we see the stock as fully valued at current levels.
We initiate coverage with a Hold recommendation.
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