Coles may be Australia's second largest grocer but it is lagging way behind market leader Woolworths in the stock market. Dave Robertson probes a company that needs to ignore the analysts and put customers first if it is to pose a serious challenge to its rival.

Woolworths and Coles may control two thirds of the Australian grocery sector, but as far as the stock market is concerned it is far from an evenly balanced duopoly. Woolworths has outperformed an already booming share market by 6% in the last year while Coles has underperformed by 9%. Woolworths' food division increased earnings before income tax by 23.1% in the last six months while Coles managed just 3.1%.

However, Woolworths is in no position to sit back and enjoy the plaudits because, when it comes to global food-industry standards, neither Woolworths nor Coles particularly impresses. Both Australian chains look at least ten years out of date when measured against Tesco's instore offerings or Wal-Mart's back-of-store organisation.

The much praised and highly profitable Woolworths, for example, has confusing aisle layouts, almost nothing in the way of store-prepared meals and a deli section that promotes a lump of feta cheese and a few olives as the height of sophistication.

But if Woolworths is off the pace in terms of international best practice then Coles is about to be lapped. The latter group feels like a store that thinks its customers still find supermarkets a novelty.

Part of the problem is that Coles is just one division of the retail conglomerate Coles Myer, which includes department stores, Officeworks and the Australian versions of Kmart and Target. Until last week, the argument was that investment in the food division has lagged because other divisions needed more attention, particularly the Myer department stores. But the other divisions are now performing reasonably well and the department stores were sold two weeks ago for A$1.4bn, leaving Coles Myer chief executive John Fletcher with nowhere to hide from his underperforming supermarkets.

This was made abundantly clear last week [21 March] when Coles Myer announced its first-half results. Net profits were up 10.5% to A$484.5m (US$384.05m) but this was largely as a result of a strong performance by Target. The supermarkets managed profit growth of only 3.1% and like for like sales were up just 0.9%. ABN Amro subsequently pointed out that with food inflation of about 2%, food volumes had actually retreated by about 1%.

ABN Amro analyst James Casey said: "The decline rate of sales growth of Coles's supermarkets business and the ever widening gap between Coles and Woolworths is troublesome. The first-half profit result has done little to allay our concerns with regard to future profit growth and we maintain our sell recommendation."

But Coles has a plan to catch up with Woolworths and the fight back is underway. The company has initiated a series of cost-cutting measures (in imitation of its rival) and hopes to strip out A$485m by 2008.

Coles is also putting in place more sophisticated ordering systems, packaging systems and is cutting the number of deliveries to each store.

In another Woolworths-inspired strategy, Coles is trying to strong-arm discounts and concessions from suppliers while increasing the amount of private-label products it stocks.

Fletcher admitted last week that Coles was about 18 months behind Woolworths in implementing these changes (and a decade behind its global peer group) but there was no "magic dial that we're about to turn" to catch up any faster.

As part of the Coles fight back other changes have been announced at the company, including streamlining the management structure. Two senior food division executives are departing (Hani Zayahi and Gerry Masters), allowing Fletcher to take direct control of the supermarkets. He says he will now spend half his week in stores, working out what can be improved.

Critics have pointed out that Fletcher should have considered doing this five years ago when he took over at Coles Myer after a career at logistics group Brambles. At the time he admitted he hadn't been inside a supermarket in 25 years, which suggested the head-hunters were either desperate or inspired.

The rest of the Coles turnaround strategy will be unveiled as a new five-year strategic plan in May. Increased liquor sales and more petrol outlets are likely to figure strongly. However, even with all these measures underway, or proposed, a number of analysts remain unconvinced that Coles will be able to seriously challenge its rival in the near future (only two of 12 had a "buy" recommendation for the stock last week).

One of the worries is that the company has only paid lip service to its desire to increase sales. Analysts and major shareholders have both pointed out that Coles is undertaking a lot of measures that seem designed to bolster profits while it is not doing much to stimulate customers.

Merrill Lynch analyst David Errington said: "Coles Myer looks as though it is grabbing profits as it is not passing on the reduction in purchase price to its customers. If the company was being managed for long-term sustainable growth, we believe it would pass on or reinvest a large part of the increased gross margin to stimulate sales growth. Woolworths looks to be on a virtuous circle of lower costs feeding into lower prices to drive higher sales and profits. Coles Myer looks to be in a vicious circle of higher costs."

In effect, what certain sections of the financial community are saying is that Coles Myer is more worried about keeping them happy than keeping customers happy. This is understandable given the praise heaped on Woolworths by investors in recent years but it is almost certainly a self-defeating strategy.

Coles needs to stop trying to please the share market. It needs to stop pretending it can match Woolworth's financial performance. It even needs to stop trying to catch up with Woolworths in the retail market.

What Coles should be attempting instead is to catch up with the best in the world rather than just the best in Australia.