Coles counts on pester power

'When you're on a good thing, flog it to death' must be Coles Group's motto for the 2019 financial year. The first quarter was boosted by the Little Shop plastic miniatures promotion, with same-store sales for its supermarkets division growing by 5.1%. But the second quarter - absent the plastic fantastic - was a bit of a fizzer, with the figure easing to just 1.3%.

Coles again decided to use pester power to its advantage in the third quarter, launching a new plastic collectibles promotion called Fresh Stikeez. While the law of diminishing returns surely applied, the promotion worked adequately. Coles has just reported same-store sales growth for the third quarter of 2.4%, a little better than market expectations.

Sales growth was however also boosted by 0.9% price inflation in fresh food. The drought, cyclones and commodity price inflation have all contributed to inflation in most fresh categories. We'd expected the supermarket groups might start benefiting from a little more price inflation than historically, but these issues are only temporary positives for Coles.

So where does our recommendation sit five months on from our initial Buy recommendation?

On sales growth, the 2019 year has unfolded about as expected. The second quarter was poor - for both Coles and Woolworths - but there's been some improvement in the third. The absence of a promotion in the fourth quarter means sales growth will probably ease again. In fact, management confirmed as much on yesterday's conference call.

Earnings evaporation

Profit expectations have fallen since our initial upgrade, however, mainly due to the evaporation of $130m of earnings following a restructuring of the fuel alliance with Viva Energy. This was painful and largely explains why our Buy price declined from $14 to $12.50 in a relatively short space of time. Fuel volumes will take time to recover, so the Express division is likely to make a small loss in 2020. It will be a headwind given Express should produce around $50m of operating earnings in 2019.

Strategically, management has confirmed its supermarkets business is weaker than Woolworths' (as expected). We were aware the company's supply chain was somewhat behind its larger competitor and it is building new distribution centres to help rectify that.

The strong growth of online sales - which remain unprofitable - is a structural challenge for the supermarket sector too. Coles has been taking steps to make this channel profitable, including signing a deal with UK-based Ocado to deliver online grocery delivery services in Sydney and Melbourne.

Then there is the store network. Coles's store network is clearly weaker than Woolworths; momentum seems to have been lost in the latter years of Wesfarmers' ownership. Coles has lost market share in New South Wales, where it also needs to refurbish stores. Most worryingly, management has confirmed that recent returns from refurbishments - which usually result in strong sales uplift - have been below expectations.

There are basic retailing issues that need fixing too. Staff rostering and product availability need some work; these are issues that Woolworths has already resolved during its turnaround.

These various announcements amount to 'bad news'. But as we've said before, we need to take management incentives into account. Managing director Steven Cain's long-term incentives began being measured around the time of the interim result, so it has not been in his interest to talk up Coles's performance until recently. Of course the previous management team's problems are now his to fix.

Evaluating management

Speaking of management, we're reserving judgment for now. We've heard Cain speak four times now and he hasn't impressed us the way Woolworths' Brad Banducci immediately did. It's a little discouraging given we're relying on Coles's management to improve the company's performance. It's something we'll continue to evaluate.

So the first five months of our Coles recommendation has been slightly disappointing. The supermarket industry is becoming more challenging, while Coles itself seems more damaged than we originally thought.

The valuation has to some extent saved us. Coles was significantly cheaper than Woolworths and remains so. The share price is now approaching our original entry price again and we've had some decent opportunities to average down.

The stock, however, is now above our Buy price, which means we're downgrading a notch. Cain expects to flesh out his strategy for Coles at the company's Investor Day in mid-June and we'll be looking for more details about how the company intends to grow sales without plastic toy promotions and drought-induced inflation. HOLD.

Disclosure: The author owns shares in Coles and Wesfarmers.

Note: Our Model Growth Portfolio owns shares in Coles and Wesfarmers. Our Model Income Portfolio owns shares in Coles, Wesfarmers and Woolworths.

Note: The Intelligent Investor Equity Income Fund owns shares in Coles, Wesfarmers and Woolworths.