Coles’ (ASX: COL) core supermarket business delivered fiscal third-quarter sales growth of 4%, supported by promotional activity and a brief spike in pantry demand as consumers worried about potential shortages due to the Middle East conflict. This lagged the 6% growth of Woolworths’ supermarkets.

Why it matters: The tables have turned, and Coles is now underperforming Woolworths over the last two quarters following an extended period of outperformance. But we believe relative advantage rarely lasts, and we expect Coles’ sales momentum to match that of Woolworths again from fiscal 2027.

  • Supermarket margins are under pressure. We expect Coles will likely absorb some of the temporarily higher fuel costs, mirroring Woolworths’ approach, and expect this to weaken EBIT margins in the second half. We forecast 5.6% for fiscal 2026, down from 5.8% in the first half.
  • Online growth is another margin headwind. Online sales grew 25% on last year, similar to Woolworths. But e-commerce is less profitable than in-store sales due to fulfilment costs. Combined with elevated discounting, this is likely to weaken supermarket margins in the near term.

The bottom line: Our earnings estimates are broadly unchanged, and we maintain our $16.50 fair value estimate for no-moat Coles. Both supermarket operators screen as overvalued, but wide-moat Woolworths screens as relatively cheaper than Coles.

  • To justify Coles’ current share price, we need to assume a supermarket EBIT margin of 6.9%, compared with 5.5% in fiscal 2025. We believe such margin expansion is unlikely in the low-growth supermarket industry, which is facing a negative mix shift to online as well as price-sensitive shoppers.
  • We instead expect supermarket EBIT margins to average 5.4% over the next decade, as efficiency gains are eroded by competition. We expect Coles to maintain its market share at 28%, with sales growing 4% per year, broadly in line with the market.

Competition restrains Coles’ long-term margins

Coles Group’s businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales. The quality of these cash flows is high and with cash generation of around 100%, we expect the dividend payout ratio to average over 80%. Coles’ investment appeal as a defensive income stock is further underpinned by its strong balance sheet, manifested in investment-grade credit ratings from both Standard & Poor’s and Moody’s. Operating leases have an average lease expiry of around six years, providing the group with the flexibility to optimize its store network.

Coles operates the second-largest supermarket chain in Australia. The group gradually expanded its market share under Wesfarmers ownership, peaking in fiscal 2016. Since then, we estimate Coles lost some 160 basis points in market share, chiefly to Woolworths. Over recent years, the combined market share of the full-service supermarkets, Coles and Woolworths, has been steady at 65%. At the same time, Aldi gained market share, while the independent supermarkets and grocers were the losers and the IGA network’s market share shrank.

Coles supermarkets currently capture 28% of Australian food and grocery retailing, compared with market leader Woolworths at 36%, the IGA network at 9%, and Aldi at 9%. Costco operates membership-only warehouses and has a market share of under 2%. The US giant commenced trading in Australia in 2009 and currently operates 15 warehouses.

E-commerce penetration of Australian food retailing remains low, at around 7%, with Coles and Woolworths as the dominant online players. We expect in-store sales to continue to dominate total industry sales for at least another decade, accounting for about 90% of revenue. However, we estimate incremental sales growth is increasingly sourced from online. Therefore, we anticipate optimizing e-commerce economics and convenience to be key focus areas of supermarkets.

Bulls say

  • Coles’ market-leading position and difficult-to-replicate store network are competitive advantages over smaller existing competitors and any new entrants.
  • The significant market share of independent supermarkets and grocers with lesser buying power over suppliers due to their smaller scale provides an opportunity for Coles to further consolidate the markets and take share.
  • Coles is a leader in e-commerce food sales in Australia. Together with relatively low online penetration, the threat from online-centric competitors to Coles’ core supermarkets business is manageable.

Bears say

  • Coles could face significant loss of market share to Woolworths, new entrants like Amazon Fresh, or to existing competitors with higher sales growth rates like Aldi and Costco.
  • Coles’ strategies are easily replicable by arch rival Woolworths. The two market leaders have a history of mimicking each other’s initiatives. The limited potential for long-lasting operational advantages makes differentiation challenging beyond just pricing.
  • Despite the relatively low online penetration of Coles’ supermarket sales, the fast-growing e-commerce channel dilutes food EBIT margins.