Coles: Interim result 2019

Coles Group's financial year started well enough. But it appears the company's Little Shop promotion just delivered a sugar rush - much like the confectionary aisle in your local supermarket.

The plastic collectibles helped same-store sales jump 5.1% in the first quarter - but it eased to 1.3% in the second quarter, proving once and for all that miniature plastic Weet-Bix and Tim Tams were indeed completely pointless.

We didn't expect supermarket margins to improve in Coles Group's inaugural interim result but in fact the opposite happened. While supermarket division sales rose 4% to $16.2bn, operating profit was flat at $602m. The operating margin fell slightly to 3.7%.

The problem was costs. Wages and energy expenses rose, as they tend to, while the transition away from single-use plastic bags hurt as well. Same-store sales growth of just 1.3% just isn't fast enough to escape the drag of rising costs.

New managing director Steven Cain - still wearing his training wheels on the conference call - mentioned a few other problems as well. Unfavourable weather was called out (is there any other kind?), as were market share losses in New South Wales. Coles has fewer stores per capita in the state compared to Woolworths, while the ones it does have are in greater need of refurbishment. Perhaps it's no coincidence that Coles' online grocery business - now at $1bn in sales - is growing fastest in NSW.

There's more Coles can do to improve the performance of supermarkets but it looks like it will be a slow road ahead. In the stores, the food offer needs continual reinvention, with work needed on its fresh and food-to-go ranges. The supply chain also needs modernising, which is why the company recently signed a six-year $950m deal for two new automated distribution centres in Queensland and New South Wales.

Demon drink

The ultimate success of our Coles recommendation will depend on how its supermarkets perform over time, so this is the division to watch. But at least the company's much smaller liquor business delivered some good news in the half. While sales were flat at $1.7bn, good cost control meant operating earnings rose 7% to $85m. The First Choice brand looks to be on the way out, with the company having converted 15 stores to 'Liquor Market' (which, being bright yellow, could be confused with a JB Hi-Fi).

The bad news about the Convenience division - now renamed 'Express' - was delivered a few weeks ago. Fuel volumes plummeted 16% in the half, showing that the alliance with Viva did indeed require renegotiation. Sales revenue fell 2% to $2.9bn, while operating earnings fell 39% to $51m. The second half will be breakeven, as will the entire 2020 financial year under the new alliance arrangements, so that's the best result we'll see from the Express division for some time.

Putting it all together, group sales rose 3% to $20.9bn and operating earnings fell 6% to $733m. All these are underlying figures, with the demerger and a switch to a retail reporting calendar making the statutory numbers meaningless.

No interim dividend was declared, as expected. Wesfarmers will pay a dividend that reflects earnings from Coles up until the November demerger date. Coles Group will pay a final dividend in September 2019, which will reflect its ownership of the businesses over the seven months to June 2019.

Watch the incentives

As mentioned before, Steven Cain had little incentive to report a good result this half. It was too early for him to have made a difference anyway, but his incentives are to boost Coles Group's performance from here.

Unfortunately there may not be much progress in the second half. Cain noted in his outlook statement that current sales momentum is consistent with the second quarter, which means costs are likely to continue rising faster than sales in the short term. Having originally expected underlying earnings per share of around 73 cents this financial year, 66-67 cents now looks more likely. Based on that, we're reducing our Buy price from $13.00 to $12.50.

We knew when we bought the stock that Coles was marked-down merchandise, just as Woolworths was back in 2016 (Woolworths' earnings also got worse before they got better). Cain's incentives were to get all the bad news out with this result, so perhaps it was bound to disappoint. We're sticking with BUY.

Disclosure: The author owns shares in Coles and Wesfarmers.

Note: Our Model Growth and Model Income portfolios own shares in Coles and Wesfarmers.

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