Coles Group Announces 10% Drop in Profit Forecast and Opens the Door to Pirate Equiteers

MELBOURNE AUSTRALIA (Daily Reckoning) - Occasionally we look at the market and think, "hang on, that doesn't seem quite right."  We had that reaction on Friday following the profit downgrade by Coles Group (ASX: CGJ) and their announcement that the company would be put up for sale.

Back to that in a moment.  The All Ordinaries index strolled through the 6,000 point mark on Friday, following on from the ASX/S&P200 the previous day.  It has all been followed with much fanfare.  The front page of Friday's Australian Financial Review was positively glowing with a huge font displaying the previous day's close.

The weekend edition was slightly more restrained, leaving it's bravado and excitement for the inside pages.

For the week the All Ordinaries had gained by 1.2%, but as we mentioned earlier in the week, everyone was expecting this benchmark and in all likely hood it had become a self fulfilling prophecy.  Now the market has its sights set on the Lucky 7,000 mark.

Looking at Vanguard's graphical representation of the Australian market in last Friday's paper we can see that the market has taken a pretty steep ride especially in the last two years.  But is it steep enough?  If the Australian market surges ahead to 7,000 points within the space of a few months we could be looking at a crash of 1987 proportions.

In the current environment, a sure and steady advance appears to be the least likely course of events.  Unsure and rough seems more likely.

The reaction of the market to the news from Coles Group really helped to sum up the mood.  And it isn't just the attitude of investors, the attitude of company directors is of equal amazement.

Here is Coles, which hasn't exactly set the world alight during the last five years, which has had more management and board stoushes than a Hells Angels get-together, and which has consistently trailed its more able competitor Woolworths (ASX: WOW) from Sydney - announcing that its profit forecast for the year would be 10% less than forecast.

This is despite the company having effectively told private equity interests a matter of four months ago to get stuffed because the current management could produce better returns than anyone else.  So confident and full of themselves were they that the board didn't even bother to put the matter to shareholders.

This was despite the Coles Myer share price having severely underperformed the return of the All Ordinaries over the last five years.  Instead of accepting the opportunity to get themselves out of a situation of their own making, chairman Rick Allert and chief executive officer John Fletcher decided that they knew better than anyone else.

They told the private equity consortium to go away and then proudly predicted that they could increase profits for Coles themselves.

Most investors seemed to believe them until the bombshell last Friday when they announced that the profit target would be missed by a full 10%.  How could they get out of this without causing the share price to plunge?

They took the gamble of a lifetime to announce that the company would be open to offers for it to be acquired!  Amazingly their gamble worked!!  Shares in Coles Group soared by 10% as investors reasoned that private equity firms would be falling over themselves to pay an even bigger premium for the company despite the fact that it is already up around 40% from its pre-takeover offer price from last year.

We admire their audacity.  If Coles Group is acquired by a private equity firm or any other firm at this price then we can surely see this as confirmation of a market 'bubble.'  But it would seem equally likely that those same private equity firms that tried to buy the group last year will keep their cheque books ensconced in their jacket pockets.

The Coles board and management may have been smart in the short term - Friday - but will they look so smart if there are still no offers in one or two weeks, or one or two months?  The longer the time passes between now and an announcement of a takeover can only result in the share price edging lower.

Kris Sayce
for The Daily Reckoning Australia

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