In the second part of this week's focus on the Australian food retail market, David Robertson looks at Woolworths' main rival, Coles Myer, which accounts for around 16% of all retail spending in Australia. With fears that its general merchandise stores may be hampering the growth of its supermarket division, does it present a viable challenge to Woolworths?

Australia's largest retailer, Coles Myer, consists of a solidly performing food business, Coles, and a collection of general merchandise stores that many investors believe are hampering the supermarket division's growth prospects. Coles Myer accounts for about 16% of all retail spending in Australia and is made up of stores like Kmart, Target, the Myer department stores and Officeworks.

The supermarket division, Coles, has been overshadowed by the success of its rival, Woolworths, in recent years but many analysts argue that this is partly due to the general merchandise stores sucking up capital expenditure and, at the same time, dragging down the company's overall performance. The debate over whether Coles Myer should demerge the general merchandise stores and concentrate on competing with Woolworths in the food sector pops up every quarter when the latest sales figures emerge.

For example, the Megamart chain of electrical goods stores lost A$18.5m (US$32.2m) in the second half of 2004 - or A$2m a store. Why, investors ask, should the company support these underperforming stores when greater investment in Coles could reap much bigger rewards?


Also, there is a question over whether Coles will end up competing against stores like Target and Kmart. Like nearly every supermarket in the world, Woolworths and Coles have both realised that there are gains to be made by offering more non-food items in their stores. But the sorts of products typically offered in a supermarket are exactly those found in Kmart and Target. This will inevitably lead to the cannibalisation of Kmart and Target sales - at a time when Kmart in particular is struggling. But if Coles Myer decides to hold back non-food growth in Coles to protect Kmart, investors are likely to start agitating for demerger at an even louder volume.

However, even if we ignore the general merchandise issue, it is clear that Coles has not kept pace with its rival Woolworths. For example, in the third quarter of 2005, comparable sales in Coles Myer's food division were up 3% while comparable food sales at Woolworths were up 6.1%.

Will Coles forever be the ugly duckling of Australia's food retail industry? Perhaps not. Coles is now showing more innovation and aggression than it has done for years and in some areas it even looks to be pulling ahead of its great adversary.

Squeezing suppliers

One important development at Coles is the imitation of Woolworths' back-of-store cost squeeze. Woolworths started its programme a few years ago and it has produced billions of dollars in savings. Coles is also now starting to overhauling its back-of-store functions with an A$800m transformation of its supply chain. As part of this strategy, Coles will build new distribution centres in Sydney and Melbourne. This simplification of the distribution network, as well as the transfer of distribution and storage costs to suppliers, should help to boost profit margins.

Coles also appears to be adopting a strategy favoured by British supermarkets in offering more own-label products. Coles has said it wants to treble the amount of own-label products to 30 or 40% of total inventory. This has sparked angry accusations from suppliers that the company is looking to source from overseas but Coles has insisted the own-label move is not "Armageddon for Australian suppliers".

Despite these assurances, it seems likely that the own-label move will again put pressure on supplier prices. Woolworths has wrung millions of dollars in savings out of its suppliers in recent years and it looks like Coles may go even further - and this could allow it to get back on level terms with its opponent.

The liquor and petrol battlegrounds

In the important areas of liquor and petrol sales, Coles appears to be edging ahead of Woolworths. Coles has about 620 liquor store outlets, including the Liquorland chain, and is buying more every quarter. But in Australia, new liquor licences are difficult to come by and are often linked to ownership of a pub (or 'hotel' as they are sometimes called down under).

As a result Coles and Woolworths have been on a pub-buying spree, with Woolworths spending A$1.3bn on Foster's former pub estate at the end of last year. However, managing pubs is notoriously difficult. British brewers have been forced to give up their pub estates and both the Australian brewers (Foster's and Lion Nathan) have sold theirs. It is difficult to see how a retailer will do any better than a brewer in running a pub chain. Also, expecting the liquor stores, which are often attached to the pubs, to subsidise the estate doesn't sound like great business.

Of course, a change in the law to allow more stand-alone liquor stores would certainly help but sceptics have plenty of evidence to back up their view that a supermarket will be no better at running a pub than a brewer - and investors should be aware that this could cause problems for both retailers in the future.

In the provision of petrol, Woolworths and Coles are again going head to head to dominate the market. At present, Coles seems to be winning. It has 597 petrol outlets compared with Woolworths' 470. And more importantly, Coles Express, the forecourt convenience stores, appear to be taking off. Fuel-related sales at Coles have grown to A$4bn compared with A$2.4bn at Woolworths.

A superior business

Coles' strength in these areas, as well as its determination to find cost savings in distribution and supply, have started to impress analysts. Morgan Stanley recently said: "The [Coles] food business is very stable: if anything, private label, general merchandise in supermarkets, and cost reductions could generate additional earnings through richer margins."

The investment bank believes that because Coles has room to improve it represents a good opportunity for investors: "Woolworths is a far superior business to Coles; however, at current levels Coles represents a better investment."

Coles is beginning to show that it can get back on level terms with Woolworths, but it still has some way to go. Cost savings through distribution simplification and the development of more own-label products will help to do this but only if those savings are re-invested in the supermarkets or given back to consumers as price cuts. If the savings are used to prop up other parts of the Coles Myer empire, the food division will surely continue to languish behind Woolworths.