Coles will spend more than $700 million over the next five years building two new automated distribution centres to replace five existing warehouses in an attempt to secure a step-change in costs and catch up with arch rival Woolworths.
The significant investment by Australia’s second-largest food and liquor retailer will dent bottom line profits in its first year as a stand-alone listed company. Coles said on Friday it would book provisions of between $130 million and $150 million in 2019 to cover the cost of closing the five warehouses, including job losses and exiting leases.
But the two new distribution centres for room temperature grocery items, as opposed to chilled, to be built in Queensland and NSW by the Australian arm of German-based company Witron Logistik + Informatik could help Coles slash operating costs. This could enable Coles to continue to reduce prices while improving profit margins, which would please investors.
While in-store, shoppers may notice fewer empty shelves and improved service from staff who are more productive.
Coles has not detailed the cost or size of each new centre, but based on Woolworths’ $350 million investment in a fully automated distribution centre in Melbourne, analysts estimate Coles’ total investment, including automation, leases and restructuring, will easily exceed $700 million.
Bank of America Merrill Lynch analyst David Errington questioned the investment, saying Coles needed to spend more $1 billion ‘to get back into the game” and the spending would dilute returns.
The investment was announced on Friday ahead of the release of scheme of arrangement documents for Coles’ proposed $20 billion demerger from Wesfarmers.
Wesfarmers intends to retain a 15 per cent stake in Coles and 50 per cent of Coles’ FlyBuys loyalty business, but Wesfarmers chief executive Rob Scott has not ruled out selling the stake at the right price in the future.
Mr Scott told AFR Weekend the demerger was still in the best interests of shareholders, despite the fact that Wesfarmers will be more exposed to the housing sector and discretionary consumer spending, with about 75 per cent of earnings coming from retail.
“This demerger is about setting up both businesses for the long term,” Mr Scott said.
“It’s important to look beyond short term trends, the time is right following a successful turnaround of Coles to move to demerger.
“I’m very confident in the growth outlook and the resilience of the Wesfarmers businesses under a range of economic circumstances.”
Wesfarmers has received court approval to proceed with the demerger, which will be put to shareholders for approval at a scheme meeting on November 15. Coles shares are expected to commence trading on November 21.
The Wesfarmers board has recommended shareholders vote in favour of the demerger, which will tilt the conglomerate’s portfolio towards businesses with stronger growth prospects, including Bunnings, Kmart and Target, Officeworks, chemicals, fertilisers and energy and industrial and safety.
Independent expert, Grant Samuel & Associates, has concluded the demerger proposal is in the best interests of Wesfarmers shareholders.
Mr Scott said the investment in supply chain automation had been under consideration for four or five years and was expected to deliver significant productivity improvements, including better safety, better on-shelf availability and freeing up the time of in-store staff through improved picking, packing and despatch.
Coles has not yet publicly revealed the location of the five DCs that will close progressively over the next five years. Staff were told of the closures on Friday.
Analysts have long held the view that Coles needed to significantly step up its investment in supply chain automation to keep pace with Woolworths, which has invested about $600 million over the last two years, including $350 million on a state of the art automated DC in Dandenong South in Melbourne due to open in early 2019.
Asked why Coles had not made the investment before the demerger, Mr Scott said: “the timing has been 100 per cent driven by Coles, it hasn’t been driven by Wesfarmers.”
“We’re seeing the technology in DCs moving so quickly the opportunity we have today is far superior to the opportunity we were presented with five years ago and you need to make sure your internal processes are strong before you embark on this type of investment,’ he said.
Coles’ new managing director, Steven Cain, who will receive a $3.9 million cash sign-on bonus, said Coles was well positioned for success over the next decade.
His six-pronged growth strategy includes a better fresh food offer, a shift away from promotional discounts towards every-day low prices, meeting customer demand for more convenience, including click and collect, home delivery and small format convenience stores, tailoring store offers to suit local markets rather than a one size fits all approach, and using technology to reduce costs.
Coles will incur one-off separation costs of about $25 million and additional operating costs of about $56 million a year because of corporate overheads and self-insurance costs.
Coles’ same-store food and liquor sales grew in the June quarter at the strongest pace in two years and analysts expect same-store supermarket sales to rise as much as 5 per cent in the September quarter, outpacing Woolworths’ for the first time in two years.
However, they believe Coles’ outperformance might be short-lived and Mr Cain needs to come up with new strategies to take market share from Woolworths and Aldi.
Coles has secured bank facilities of about $4 billion to support net debt of about $2 billion. The bank facilities will provide significant liquidity headroom to cover cash flow variations, including peak working capital requirements, capital expenditure, dividend payments and bank guarantees.
The capex associated with the new distribution centres is included in Coles’ net capex guidance of $600 million to $800 million, which compares with capex of $715 million in 2018.
The demerged company will also have operating lease commitments of $9.6 billion and is expected to pay out 80 to 90 per cent of earnings as dividends from 2020.
Eligible shareholders will receive one Coles share for every Wesfarmers share.
Analysts believe Coles will have an enterprise value between $16 billion and $19 billion – making it a top 30 company – and will trade at a multiple of about 10 or 11 times EBIT and 16 to 17 times earnings per share – a 10 to 20 per cent discount to Woolworths – suggesting a share price between $14 and $15.50.
Article credit – www.afr.com