Can Coles make it a Big 5?

Financial Journalist
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With bank stocks near record highs, the thought of the giant retailers entering the home-loan market is captivating. Done well, it could help offset sluggish retail sales growth and provide a new long-term earnings growth engine.

The real disruption

The big question, however, is not whether Woolworths and Wesfarmers, via Coles, can make inroads in personal lending. Of course they can. Rather, it’s the size and timing of those inroads, the effect on earnings, and whether the retailers’ valuations already capture the upside.

An even better question is: could the market be underestimating the disruptive effect of the big retailers exploiting their massive databases, customer analytics and data-mining skills, and their ability to cross-promote products and financial services, and provide point rewards?

Coles’ unveiling this month of plans to issue personal loans, and its potential alliance with GE Capital, captured headlines, even though its push into retail financial services has been building for some time. There is longstanding speculation that Coles will apply for a banking licence, which would enable it to accept deposits. At this stage, Coles’ broader intentions in financial services are unclear.

Woolworths also attracted headlines, albeit unwanted, about its “banking” services. Newspapers reported that Woolworths had incorrectly used the word “bank” in its advertisements, and risked irking the Australian Prudential Regulation Authority (APRA).

Some perspective is needed. Prominent British retailer, Tesco, provides a useful benchmark for Woolies and Coles’ potential foray into home loans. It had built a £700 million loan book at the end of 2013 – about a 0.05% share of the British mortgage market – in 18 months since launch.

A fifth force?

Extrapolating that to Australia, a 0.05% share of our $1.37 trillion market equates to a $680 million loan book for Coles. If Woolies did the same, the retailers would have 0.1% market share in their first 18 months – hardly a fifth force in banking.

The big-four banks control about 84% of owner-occupied and investment housing loans, according to ARPA. The top 10 market players have a combined 96% share. Market leader Commonwealth Bank has a 27.2% share, according to ARPA.

At best, Woolworths and Coles would build a small market share, at least in the short term, assuming they successfully entered the home-lending market. And assuming that the competitive response from the big-four banks, which acutely understand the long-term threat, does not stop the retailers in their tracks.

Moreover, Coles’ $680 million home loan book would deliver $4 million in earnings before interest and tax (EBIT) for Wesfarmers, using Macquarie Equity Research numbers. With EBIT of $3.53 billion in 2013-14, an extra $4 million for Wesfarmers is barely material, although it would grow over time.

The market understands the limited effect on Wesfarmers’ earnings, and for Woolworths if it followed its rival’s lead. Wesfarmers has a one-year total shareholder return (including dividends) of 11.6% to July 29, 2014. Woolies is up 11.8%. Both have underperformed the 15.6% gain in the S&P/ASX 200 Accumulation Index over one year.

So why even bother analysing the retailers’ potential in home lending if the most likely outcome is a tiny market share and a minimal effect on earnings? It’s because the market, as is its way, is looking 18 months ahead when the long-term investors, such as SMSFs, should take a multi-year view on core equity investments.

The long-term

On a longer-term view (five years plus), the retailers’ likely move into home lending has intriguing potential. The market is probably underestimating the confluence of technological trends, as consumers move to electronic “wallets” in coming years (with smartphones replacing traditional wallets) and the increasing power of “big data” as retailers mine customer information.

Imagine the potential of Woolworths and Coles analysing 18 million transactions each week, and learning more about their customers than ever, thanks to smartphones being used as payment devices. Potentially, they’ll be able to tell which customers are in the market for a new home loan, or to refinance an existing loan, well before the banks, based on spending habits.

If Target in the US can figure out when women are pregnant well before they have told friends or family, based on their changing spending habits, I’m sure the big retailers can tell which customers are in the market for finance, and respond with tailored in-store offers.

The other potential is linking home loans to discounts for Woolworths and Coles’ supermarket, alcohol, hardware and petrol products. The big banks’ credit-card points programs are not nearly as immediate as in-store food or petrol discounts, or juicy discounts at Bunnings for a new homeowner, who suddenly spends every second Saturday morning there, for example.

If you think it through, the retailers have two potential advantages over the banks. They have more transaction touch points with customers, and thus more data to mine. And better ability to exploit “radical adjacencies”’ that combine technology, finance and retail.

One could see Woolworths and Coles each overtaking the fifth-largest mortgage provider, ING Bank (Australia), which has 3% market share, by the end of this decade. But they would still be a long way behind the fourth player, ANZ Banking Group, and its 15.3% share.

Realistic valuations

The final issue is valuation. Both retailers look fully valued in the short term, if not a touch expensive. Consensus analysts have Woolworths and Wesfarmers on a prospective 2014-15 Price Earnings (PE) ratio of 17.4 times and 19.2 times respectively. The multiple could well be higher if earnings-per-share forecasts disappoint because of Australia’s challenged household sector. More will be known when both retailers report full-year earnings.

Even so, current owners should continue to hold both stocks, and prospective owners should look to buy on significant price weakness. Both are still core portfolio holdings and a bigger push into personal lending strengthens their long-term appeal.

Great companies have a knack of juggling different streams of innovation: short-term gains from continual productivity improvements; medium-term gains from moving horizontally or vertically into related markets; and long-term gains from radical, game-changing disruptions.

The retailers’ potential move into home lending fits the third category. If they combine their offer with technology, big data, and aggressive cross-promotion of other retail products, Australia could see the boundaries of personal financial services radically reshaped. But it’s still some way off and not enough to build a case to buy Woolies or Wesfarmers at current prices.

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at 29 July 2014.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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