Coles is now battling to maintain its place atop the supermarket shelf

STEPHEN BARTHOLOMEUSZ
February 15, 2017
The Australian
Business columnist Melbourne

While the potential float or sale of Officeworks provided a surprising diversion, the real point of interest in the Wesfarmers’ interim report today was always going to be the performance of Coles. Its results confirmed that it is now locked in a torrid battle to preserve the market position it has won since it acquired by Wesfarmers nearly a decade ago. 

Coles’ earnings before interest and tax actually fell 2.6 per cent, to $920m, in a half where its sales also slipped 0.2 per cent. Excluding the impact of the sale of some property interests, the earnings decline was 6.8 per cent.

In the core food and liquor operations, Coles did lift sales 2.3 per cent and comparable stores sales 1.3 per cent compared with what was a very strong half-year in 2015-16. By its own standards, however, the result, taken at face value, was ordinary.

Appearances can be deceptive when circumstances change. Woolworths has been throwing hundreds of millions of dollars at lowering prices and improving service within its rival supermarket business, desperate to regain some of the ground and momentum it surrendered to Coles under previous management teams. 

With Woolworths apparently generating comparable stores sales growth for the first time in years in the December half, it presented Coles with the same choice that the resurgence of Coles under Wesfarmers presented Woolworths.

Rather than emulate Woolworths and attempt to hold onto margin and profitability, which was the disastrous choice Woolworths made, Coles has opted to take the challenge of a reinvigorated and refocused Woolworths head on.

Coles’ John Durkan and outgoing Wesfarmers chief executive Richard Goyder have made it very clear that Coles is prepared to invest heavily in lower prices and its own service to maintain its competitiveness, even if there is a cost to profitability. Durkan cited the competitive environment, and Coles’ “significant” investment in lowering prices and in lowering margins.

Coles isn’t, of course, just responding to Woolworths and trying to preserve the consumer perception and, until recently, the reality that its prices were lower than its arch rival’s. Aldi continues to expand, Metcash is also sacrificing margin and profitability at price and range to try to defend its independents and, in the background, is the spectre of Amazon Fresh.

While Amazon has been tight-lipped about its plan to expand in this market, it has been hiring and it has been searching for warehousing. There is an expectation that at some point, either this year or next, it will have a general merchandise and probably a dry grocery and fresh food offer in this market.

If it does come, it will be disruptive and established retailers across all retail segments will have to think through their responses, given that Amazon has tended to be less interested in near-term profitability than in building its sales and market presence over the long term.

Coles and Woolworths know that they can’t afford any level of complacency but need to keep investing in price and service, which Durkan is committed to doing. While earnings might have slid in the half, Coles reported continued growth in comparable transaction volumes, basket sizes and sales density, so, the key metric of the operational side of the business are still positive.

The “other” part of Durkan’s domain, a liquor business that has historically underperformed, is in the midst of a major transformation strategy. It has now had five quarters of comparable stores sales growth and improved transaction volumes and is, Durkan says, on track with the expectations that underpin the five-year turnaround plan for the business.

Within the rest of the Wesfarmers’ portfolio, which has, as a whole, generated 13.2 per cent earnings growth, the home improvement business’ earnings were impacted by the expected weight of the expansion into the UK, where the business lost $48m at an EBIT level.

Bunnings UK has only just opened its first pilot store, to what appears to be a generally positive reception. It will take at least two or three years to get a better sense of the UK business’ performance and potential.

Overall, the home improvement division grew EBIT by only a modest three per cent, but the core Australian operations generated earnings growth of 9.8 per cent and improved its already-remarkable return on capital to 39 per cent.

The performance of the department stores, Kmart and Target, was not dissimilar to that of the home improvement grouping, with Kmart continuing to generate impressive earnings growth (up 16.3 per cent) and Target, now in the midst of a complete restructuring, pushing the two brands’ combined earnings down 1.5 per cent. 

Guy Russo, who oversees both brands, sees this financial year as a “transitional” one for Target but also appears to see progress on costs, store productivity, inventory management and merchandise disciplines.

The industrials division, led by Wesfarmers CEO-elect Rob Scott, had a good half, lifting EBIT from $22m to $377m, with major improvements in the contributions from the chemicals, energy and fertiliser segment (up 79.8 per cent) and resources, where the dramatic rise in coal prices helped transform the result from a loss of $118m to a profit of $138m. 

The most intriguing aspect of the result was the revelation that Wesfarmers is conducting a strategic review of Officeworks, which reported a 5.1 per cent increase in EBIT to $62m on a sales increase of 5.9 per cent and a return on capital of 13.9 per cent. 

Officeworks, while perhaps sub-scale relative to Wesfarmers’ other retail brands, has been a quiet achiever in recent years. 

Almost an afterthought when the Coles Group was acquired in 2007, and for a long time managed as an appendage to Bunnings, it has more than doubled its earnings and returns on capital over the decade and, under Mark Ward, has significantly broadened the range of products and services it supplies to its targets markets of small and medium-sized businesses and households.

Wesfarmers didn’t explain why it was considering the options for monetising the business. It might reflect a view of the maturity of the business and of its future growth prospects, although its performance tends to suggest there is still a lot of headroom into which the business can grow.

Perhaps it is simply the scale issue and the competing demands for capital within the Wesfarmers’ group. Given how broadly it defines itself, with unfettered access for capital if it were separately listed, Officeworks might well be able to expand more rapidly. There might also be some consolidation options.

If it is divested, via an IPO or possibly a trade sale or private equity acquisition, it will generate a big lump of cash. If the other strategic review (of Wesfarmers’ resources/coal assets) were also to result in a transaction, the proceeds would start to look like a war chest, given the existing strength of the group’s balance sheet and Richard Goyder would be giving his successor a range of options to add his own chapter of growth to Wesfarmers’ history.