Has the Coles Group share price bottomed?

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The Coles Group Ltd (ASX: COL) share price enjoyed its best one-day gain since its listing after Macquarie Group Ltd (ASX: MQG) upgraded its recommendation on the stock.

The Coles Group share price surged 5% to $12.08 on the news with Macquarie pointing out that the valuation gap between Coles and archrival Woolworths Group Ltd (ASX: WOW) is too wide.

COL is the best performing stock on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index with the APA Group (ASX: APA) share price and Trade Me Group Ltd (ASX: TME) share price taking a distant second and third spot.

Supermarket stocks the flavour of the day

Coincidentally, the Woolworths share price also enjoyed good support as it gained 0.5% to $29.08 while Metcash Limited (ASX: MTS) share price added 1.4% to $2.48 as investors flocked to the relative safety of grocery stocks amid the market shake-up.

Coles got the extra boost when Macquarie upgraded its call on the stock to “outperform” from “neutral” after visiting Woolworth’s new automated distribution centre (DC) in the Melbourne suburb of Dandenong.

The broker was impressed with Woolies’ circa $562 million automated DC and believes that the operational benefits from the investment will also apply to Coles when it builds it two new DCs.

Good for the goose, good for the gander

For now, Woolworths is ahead of the curve on this front and the automated DC will be able to process 11,000 Stock Keeping Units (SKUs) compared to a traditional manual DC which can only handle less than 4,000 SKUs.

What’s more, the automated DCs require fewer people to run as it will employ around 150 full-time equivalent (FTE) staff compared to around 700 FTE for the old DCs.

“In addition to the direct cost savings at the logistics level, we expect indirect cost savings to be realised from reduced restocking times at the store level due to more efficiently stacked pallets,” said the broker.

“A point of conjecture for Coles has been the path for the balance sheet given commitment to two new automated DCs over a five-year period (QLD: 2022; NSW: 2023). Whilst the spend is unknown, we estimate a 12% ROIC [return on invested capital] is possible longer term on a $1bn spend.”

Coles share price looking too cheap

The market knows Coles has a large capex ahead of it as it plays catch-up to Woolworths. This will limit Coles’ ability to raise its dividend and/or to contemplate any capital returns.

But even though Coles is lagging behind Woolworths, the stock is looking too cheap.

“With a strong market position (~809 SM stores) and broad macro drivers supporting demand, Coles will appeal to defensive investors,” said Macquarie.

“Whilst WOW is more advanced in its automation efforts and has better scale, COL is trading at a ~6 PE point discount (ex-petrol) and offers twice the yield.”

Based on the broker’s estimates, Coles is trading on around a 7% yield if franking credits are included. Macquarie has a price target of $13.48 on the stock.

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Motley Fool contributor Brendon Lau owns shares of Macquarie Group Limited. The Motley Fool Australia owns shares of COLESGROUP DEF SET. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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