Why Citi sees inflation as a good thing for the performance of this stock

Coles Group (ASX: COL) is shaping up to be one of the ASX stocks to most benefit from COVID-era inflation after the company reported a 17% increase in profit (NPAT) over 1HFY22. 

The company pointed to high inflation for food and vegetables as supporting the tenor of the company’s first-half report on Tuesday.

In turn, Citigroup has rated the stock a BUY. 

Citi gave COL a price target of $18.30. 

Using a close price of $18.30, this reflects a total return of 3.3%. 

As at 3:00pm (AEST) Tuesday 21 February 2023, COL is priced at $18.08. 

Despite calling a higher dividend than expected and posting impressive NPAT gains, the company’s shares were down -1.20% in the last hour of trade on Tuesday.

Impressive beats 

NPAT for 1HFY23 clocked in at $643m, up from $549m for 1HFY22. 

Citi noted on Tuesday the stock’s performance beat its own expectations in two high-impact areas:

• EBIT of $1.05bn vs. Citi’s expectations of $991mn

• Interim dividend of 36cps declared vs. Citi’s expected 34.5cps

Assisting the company’s performance—to borrow an observation from Commsec—is that “normalised trading conditions have also brought down COVID-era costs.”

Underscoring this is one comment Citi analysts made regarding Coles’ improved margins in regards to online shopping channels.

“Online penetration in supermarkets declined from 7.6% in 1Q23 to 6.9% in 2Q23, benefiting margins given this is a high cost channel,” analysts wrote. 

Not all rosy 

A number of takeaways detracted from Coles’ impressive core results on Tuesday. 

Higher costs of doing business hurt the company’s liquor margins in the first-half of FY23—to such extent Citi has applied a discount to its valuation of Coles Group. 

“We apply a 10% discount to the Liquor business due to lack of scale and underperformance relative to supermarket peers,” analysts wrote on Tuesday. 

The team expects liquor sales to be better in 2HFY23 and to see this reflected in the full year report. 

As for COVID-era economic phenomena, supply chain issues continue to dampen Citi’s view on the stock, writing that “supply challenges continuing with availability metrics still well below pre-COVID levels.” 

And then there’s inflation 

One of Citi’s key risks for its valuation of Coles, perhaps counterintuitively for the uninitiated, is that inflation could subside. 

For context, the RBA revealed on Tuesday it considered a 50bps rate hike for its next move. 

“If food inflation subsides, cost fractionalisation will become difficult in the Supermarket and Liquor divisions,” Citi analysts wrote. 

The impact of deflation on Coles Group’s earnings can only wait to be seen, however, Citi does expect inflation to moderate going into 2HFY23. 

Supporting evidence from UBS 

UBS published a note on Monday looking at food and beverage inflation, highlighting that monthly price changes are declining sharply with changes in January of CY23 down -14% YoY and February to date down -17%. 

There are two big factors behind this. 

1. UBS sees supply chain improvements underpinning a softening in price volatility (notwithstanding Citi’s view supply chains continue to impact Coles Group’s performance). 

2. Vegetable prices are coming down as the 2023 year gets off to a better start than 2022 in terms of flooding. Crop conditions are better on the whole despite the flooding situation in NZ (similar to what the Australian east coast experienced last year). 

Meat prices are also stabilising, UBS noted, but remain at very elevated levels compared to pre-COVID. For those playing at home, chicken offers the best hit of protein per dollar.

COL's 1Y chart at close on Tuesday 21 Feb 2023