• Christopher Hall

Coles Group - COVID-19 Grocery volumes Skyrocket

Australians have panicked and hoarded groceries. Coles has reported 20-30% grocery volumes above their peak Christmas periods. Hugh Dive from Atlas Funds Management review the impacts to Coles' profit and looks at whether it's a buy in this current market.

[00:00:02] arch to try again in March 2020. Bad news is very thick on the ground, with many companies seeing their share prices halve. This is Miss the great uncertainty brought on by kohver 19 virus businesses being shut, borders being closed across Australia, while large percentages of the ASX understandably pulled guidance and going into crisis mode. A few ASX listed companies are enjoying record business conditions. Instead of searching the markets trash for treasure today until better Tuesday, we're going to look at a star. Coles management last week said the demand for food and groceries was up 20 to 30 per cent higher than their Christmas peak periods. The company hit a nail applied at two-pack' limit to eggs, chilled paster, frozen vegetables, frozen desserts, sugar, long life milk and canned tomatoes, as well as liquid soap, cafes and restaurants. Close sales for Coles and likely to increase. While we would hate to be seen as profiteers, it torpedoed Tuesday. What does this mission critical growth look like as an investment in these dark days? To die from Atlas Funds Management? Is he guiding us through? Good morning. Good morning, Chris. Now, before we jump into Coles and how they're making money and the torpedo or quality filter model that Atlas is well known for. Coles get to be on the ASX. [00:01:26][84.5]

[00:01:28] Well, Coles was previously listed as part of Coles Myer, but it was acquired by Wesfarmers in November 2007 in cash and scrip. Take over the value of the business. But over $19 billion. However, late 2018, Wesfarmers demerge Coles, which was listed at twelvers, studied twelve forty nine because it was viewed as sort of its growth, which is quite hilarious given the current situation and a business that could at best grow 2 to 4 per cent per annum in line with GDP. And that was viewed as a pedestrian paines compared with Wesfarmers, other more exciting high growth businesses. So it spun off and shares were given a twist on the shareholder. [00:02:09][40.8]

[00:02:10] So how big or broad is Coles as a company? [00:02:13][2.5]

[00:02:14] Colter's one of Australia's largest employers with about 12000 starta probably a bit more at the moment. As you well know, it's a full service supermarket with eight hundred seven stores across Australia providing food, groceries and merchandise cleaning products. That's running about 80 percent of the profits. They also operate 700 was inherited at Coles Express petrol station convenience stores under a line in favor energy and that's about 9 per cent. And then also Coles operates a liquor retailer. So they were at 900 stores and their brands such as nickel and ditched shelves all through those businesses designated as mission critical and will be kept open through the due through the duration of the pro-vice crisis. [00:03:00][45.4]

[00:03:01] And how does Coles make money for shareholders? [00:03:03][1.4]

[00:03:05] Well, of its business model is very simple and that they buy groceries wholesale from the manufacturers, such as my buy a liter of milk can of coke or a packet of toilet paper. These are then moved from moved from the manufacturer of Coles distribution centers and then out to the network of supermarkets and liquor stores. Additionally, sort of Coles like also it must have developed their own home brand goods, which are generally priced a little bit below that. So name-brand goods, but deliver to the supermarket a much higher profit margin when they're sold. So essentially sort of buy wholesale in bulk, sell retail individual. [00:03:39][34.5]

[00:03:41] And how profitable is a supermarket industry? [00:03:43][1.9]

[00:03:44] Well, it's very profitable at the moment, but because it's a Bremmer's of volumes, a position, it's got a low margin business. So if it margins less than 5 per cent, it's a high volume gain going through low return on capital. And that sort of reflects the nation's supermarket industries with heavy sort of capital intensive stores and distribution services. However, sort of Coles's business could condense a large amount of fixed costs, the stores and distribution, such that sort of what we're seeing now, the higher volumes going through those assets will result in much higher incremental are absolute and profits and higher margins. And that's pumping extra goods to the distribution center or through an individual store. The additional costs aren't that much greater. So yeah, they'll be doing that on the profit margins will be much higher than the very consistent 5 per cent margins that I had over the past decade. [00:04:36][51.5]

[00:04:37] So with such low return on capital and low margins, how does Coles manage their cash flow? [00:04:43][5.9]

[00:04:45] What are the sort of the interesting parts of the grocery business is that unlike I can't think of any other business that's have a cash generation wretched credit 100 percent. Most businesses have much less than that because there's like. There's a buy somewhere, build inventory, then they sell later. This sort of overharvesting cash generation ratio occurs because suppliers such as Kelloggs may maybe paid on terms between 60 or 120 days. So when coal sells a box of sugary cornflakes to me for cash, that's quicker than 60, 220 days. Effectively, Kellogg's calls the gift, giving Coles the item before they sell it. It would actually sell it to Silverbridge and the Kasser effectively. Kellogg's is funding Coles's working capital in the upcoming August 20-20 results. You'd expect Coles's cash flow conversion is much higher than 100 per cent. Given these sort of extreme turnover, selling these very, very fast and then painand supplies on 60 120 days. So what are the advantages? This is Coles typically run a negative working cash flow of around a billion dollars, which is effectively a billion dollar interest free loan from this flies sell. [00:05:58][73.1]

[00:05:58] Very nice bottle if you can get it. [00:05:59][1.1]

[00:06:00] But as you've said, it's yeah, I can't think of it. I can't think of any other industries that have it in generally. But most virtually all other industries have carried large working capital balances themselves. [00:06:10][10.7]

[00:06:12] Now, if we apply the quality filter model that Atlas is known for, the first came off the greatest financial leverage. So looking at how much debt in the business, how that ranks against competitors or the industry as a whole, how do you rate Coles Coles's financial leverage after it's come out of that place? Farmers spin off. [00:06:27][15.3]

[00:06:28] Right. So when Coles was spun up and Wesfarmers that took a large amount of Wesfarmers debt was did given the nature of the business and also the cash generation we spoke of could handle a lot of debt. However, in 2019, Coles of management actually reduced their gross debt from two billion to 1.4. And that's sort of reducing their gearing to round about 42 per cent. Here Coles scores very well for the major businesses. A business can handle it. [00:06:54][25.7]

[00:06:54] I said that a debt, especially its current quite low rates now number two rate of expansion, looking at acquisitions, growth both organically in the head of Coles right there. [00:07:04][10.5]

[00:07:05] Well, that's all very well in that asset. And revenue growth, low single digits over the past 1 5 years. That's a reflection. Coles operates in a very constrained environment in the grocery sector with a 30 per cent market share in both grocery and and also liquor in the whole market is dominated by large resourced, well resourced competitors such as what was Ali buying products effective in the same wholesalers. So any aggressive moves to take market share via price review? The areas swiftly met by Woolworths. Now we are monitoring Coles, as most ATRA will say would never well, I wouldn't allow any sort of takeovers. [00:07:46][40.8]

[00:07:48] Also sort of offshore expansion takes place, sort of that there haven't been any moves for Coles to expand offshore from there. So clearly saw the sister company Bunnings as ill fated expansion in the UK. The that didn't work very well. So that effectively sort of boxed in and kept it in Australia so that on that measure they scored quite well. [00:08:08][20.1]

[00:08:10] Now number three is corporate governance. So I think the board, the independents, the board disclosures, how do you rate Coles? [00:08:15][5.3]

[00:08:16] So here's good Coles scores, sort of mid range. They have eight out of nine independent directors. However, they question whether their chair is independent, given that the chairman has been on the Wesfarmers board since 1998. The disclosures are very good as you'd expect to see this large force very, very well, well resourced company. I actually know one of the directors quite well personally and a great degree of respect for her business acumen and judgment overall scores quite well despite the lack of the question of chairman. [00:08:51][34.6]

[00:08:53] Now number four's regulatory risk. So we're looking at how much government meddles in the business of business. They've been a lot of talk recently. But let's put this in context as a company as a whole. [00:09:03][10.0]

[00:09:03] How do you rate the regulatory risk to Coles generally as a medium to low level regulatory risk, just an intense competition. The grocery business results into a minimal mental A-Triple-C oversight, though you probably amendment 2009/10. The grocery sector, mainly Woolworths, attracted a lot of negative attention for underpaying staff, made it mainly middle management. This issue was much more prevalent in Woolworths, with Coles charged being 20 million compared to 300 million at Woolworths made changes to the penalty rates are likely to impact Coles and that's one of the largest employers with one hundred twelve thousand staff members. That's gone up with adding 5000 casuals. Hopefully some of those Qantas employees to help. It's just this unprecedented demand spike. [00:09:46][43.0]

[00:09:48] Could there be regulatory concerns with Coles seen as profiting from social unrest? Could it be similar to banks being consistently talking down market conditions? jfc. [00:09:59][11.1]

[00:10:00] That the scope of the business looks yeah, so over the next year, Mary, KOLs could well be in a situation as we have seen with the banks in the past. But they may have to, using air quotes, manage their profit results because there will be one of the few Australian companies. The report significantly higher profits in 2020 than they did in 2009, saying so there'll be a very much an outlier. So the profit guidance between 710 and similar 30 million dollars given in February is would be unwise. It is very hard to see a situation with it that isn't extended quite dramatically just due to the ship volume sales going through with restaurants and cafes closed. One of the few places people are buying these days. I mean, a very large jump in profits may cause unwanted regulatory attention by the fact that a portion of the Djibril grocery sales and 20:20 may be purchases from 2021. That's put forward if the covered 19 crises ended tomorrow. Tomorrow could imagine toilet paper in hand. Hand-sewn and other such sales could look pretty dire through the rest of the year as people been stockpiling these items with garages full of Pastor Rice, pasta sauce and all the other items blown off. [00:11:10][69.4]

[00:11:10] So there could be a bit of pull through, but not there'll be usually seeing how they communicate their message in a couple of months time. [00:11:17][7.3]

[00:11:18] Number five is technological and operating risk. Now, if we break them into two and you start off with a technological, how does that look? [00:11:26][7.6]

[00:11:28] Okay, so Wilbraham. So technology risks. There's not much an operational risk because running supermarkets is a really proud operational risks. So like various chemicals or soil as a milk spill in oil for and never can be is that that's it's it's a well it's a well sort of documented process of moving goods around and they're all relatively skillful at that. Technology has a large risk here so that online shopping and potentially the crisis is covered. 19 crisis exacerbates the shift to online. I mean, when I see Coles actually temporarily canceled home delivery using trucks to actually restock the stores. That's probably quite a prudent move to take Shell stock during strengh volumes. Similarly, sort of vano. Woolworths asked us for a review order last week to try to pick the pick up the goods in store, leaving the deliveries to those that are in quarantine and elderly. So sort of. Coles has a technology risk and the potential for store sales to migrate online fueled by Amazon. [00:12:28][60.8]

[00:12:29] Those that of food and liquor is another area that Amazon are focusing on. Coppo, Coles and Woolworths made preemptively investing in their online offering to try and predict their existing businesses. And we saw an most recent result in February. Coles online sales rose 24 per cent over the past six months and showed up. Will be a substantial lift when they reported in August. [00:12:49][19.8]

[00:12:50] What is the Amazon rollout look like in other countries that relate to Coles in more densely populated countries, for example, Germany, which I'm very familiar of. [00:12:59][9.2]

[00:13:00] Having lived there for a time. They are. Amazon only offered delivery in 10 major cities, so the German grocery market is primitive. It is similar to Australia. Intense competition, very low margin dominated by Aldi calphalon leetle. [00:13:16][16.2]

[00:13:18] So sort of. So Amazon haven't haven't gone head to head with the head of headded within the major crises in Germany across the whole country, only focusing on 10 cities. I mean, conceptually, sort of core grocers are less desirable for Amazon because if they started to deliver meat and fruit and vegetables, they would need to build large refrigerated and refrigerated warehouses. It was still quite separate to the distribution centers that Amazon had built for books and headphones and electronic gear, which obviously we don't want to be chill down to the costs. And again, they'll be quite high as part of the separation calls from. Wesfarmers Coles are consoling five of their smaller distribution centers into two large automated discription centers. And while this is expected to cost about 700 million, I'm sure they wish they had an up and running right now. It will lower Coles's operating costs and this moves as well designed to allow sort of Coles to compete with the sort of Woolies at Amazon. I think they're quite well poised to pull that off. [00:14:21][62.6]

[00:14:23] So they put out. We know that there was some competition come into Australia. Yes. Had publicly that was announced in January this year. How does that pan out and does that impact Coles? [00:14:36][13.4]

[00:14:38] Well, I mean, sort of the potential issue of kalif land, the German grocery giant Australia was going to be a bit of a big issue, a very large, very well resourced private company that can similar to Aldi, could handle a number of years of losses without sort of. And I'm out there. The public shareholders. Yes, smart mouth analysts. Complaining about what they were doing in a farflung decision and the law and obviously now Al is sort of quite profitable. I'm so in January, calphalon pulled out of Australia and that's even after investing over half a billion dollars are buying sites and building employing 700 staff. I mean, this to me is an indication that due to the geographic issues such as the size of Australia, a relatively small population, and also particularly getting sites in major cities, that it's a difficult market for even well-resourced foreign trucking companies to come in. She's also the power of incumbents. So Australia's a tough market to come in. Given that Carphone were ready to walk away from over 400 million dollars that put into Australia over every couple of years. So that sort of potentially suggests that there's the technology, which sounds great, but also knows the Amazon, it hasn't been anywhere near as profitable as they were forecasts when they came in into 2017 and said that in the JB Hi-Fi results that came out yesterday. [00:15:55][77.8]

[00:15:57] So definitely will be defended or defendable territory for Coles and Woolworths and Aldi. They got a foothold in there. This is definitely stand out torpedo Tuesday when all we're looking at those that are at the bottom and that's where it can blow up. They're very different today. [00:16:13][16.4]

[00:16:14] So we'll try to get something positive in it in all this negativity. [00:16:17][3.3]

[00:16:19] Yes, definitely a shining light or a green spark in the sea of red. What's your take and would you be adding it to the portfolio so Coles passes that quality? [00:16:28][9.2]

[00:16:28] A measure that will set the exposure to food and liquor offers investors with the defensive earning stream with the sustainable competitive advantage in the Cayman is two key markets for with large market share. And we all own Coles in the portfolio, but sold out in November above $16 just on valuation grounds. But given the changing circumstances, Coles is definitely worth sort of revisiting. Looking right now trades on a pay, not trailing pay, which is definitely representative of the future of about 19 times with a three-person yield. But assuming the COVA 19 crisis continued, we're probably. It's difficult to guess what the profit rise sales rises. Management of guys at 20 or 30 per cent. That's sort of probably on the on the downside. Yeah, but based on that, probably looking to pay about 15 times with a four and a half per cent yield and there would have been an attractive multiple five weeks ago, but one that would point out place. Coles is one of the more expensive stocks on the ASX. Cause it's stock they're watching very closely. Repro. I would like to see it folded further by dipping our toes in the water. It doesn't really feel that much. Understandably. And also be a bit wary in March 2020, buying it on an absolute sort of all time peak of earnings. Given that we do believe the prices will finish at some stage and there'll be a range of purchases brought forward into the first half of 2020. So not it not in the portfolio, but what you closely. [00:18:02][94.1]

[00:18:04] It's on the short list. Thank you very much. She died from Atlas Funds Management. Thank you, Chris. [00:18:04][0.0]


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