New Coles managing director Steven Cain has moved quickly to renegotiate an uncompetitive fuel supply deal with Viva Energy but has warned that earnings at Coles’ convenience business will fall 62 per cent this year and will barely break even unless fuel volumes improve.

Under the new 10-year agreement, Viva will set the retail price of fuel, collect the full retail margin and receive higher royalties on convenience store sales. Coles, which previously set the retail price, will take a commission on every litre of fuel sold and will focus on running the convenience stores. Viva will pay Coles $137 million upfront, funded by debt.

The new deal suggests that retail fuel prices at Coles Express — which have been 10 to 15 per cent higher than average market prices — will fall, reversing a three-year decline in volumes and enabling both Coles and Viva to regain lost market share.

However, under the new commission model Coles’ earnings from fuel will be much lower than in the past.

Coles said on Wednesday fuel volumes had continued to decline in the December-half, falling another 16 per cent to 62.4 million litres a week, compared with 100 million a week a few years ago.

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Coles expects earnings from convenience to plunge 62 per cent to just $50 million this year, compared with $133 million in 2018 and $190 million in 2017. It would just break-even in the June-half.

Mr Cain said if Coles and Viva could lift fuel volumes from 62 million litres a week to 75 million litres a week and boost convenience store sales, earnings were expected to be maintained around $50 million and eventually improve.

“That becomes a sustainable model – over the last few years it wasn’t a sustainable model,” he told The Australian Financial Review.

However, Mr Cain told analysts that if volumes remained around 60 million litres a week the business would just break even.

Coles shares fell 2 per cent to $12.48 in early trade while Viva shares jumped 12 per cent to $2.15.

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Analysts slammed Coles, which demerged from Wesfarmers in November, for not revealing the material drop in convenience earnings earlier. Coles had been in negotiations with Viva and conducting trials for two years.

“When were you going to inform the market of a material earnings hole?” asked Bank of America Merrill Lynch analyst David Errington. “There’s a pretty big earnings drop here. You’ve informed the market of a deal (today), not how bad the business has been performing.”

Mr Cain defended the company’s disclosure, saying it revealed at Wesfarmers’ AGM in November that fuel volumes had continued to decline.

Coles also revealed its convenience division previously paid an undisclosed $30 million a year brand fee to Coles Supermarkets. After the demerger this will no longer be payable, boosting convenience earnings but reducing supermarket earnings. The brand fee change was included in the guidance for 2019.

In October, shortly after taking the helm at Coles, Mr Cain said he was willing to exit the $35 billion retail fuel market to end the deal with Viva, which had saddled Coles with Australia’s highest petrol prices.

Coles’ fuel volumes and earnings have fallen by more than one-third over the past three years because its prices were higher than those at other sites such as Woolworths, Caltex, BP and 7-Eleven.

Viva took over the Coles contract in 2014 after buying Shell’s retail fuel and refinery businesses.

Coles said on Wednesday the new alliance was expected to deliver a more competitive customer offer, provide an opportunity to expand the Coles Express network and better align incentives for each party.

As Viva will be responsible for setting the retail price of fuel and receive the retail fuel margin, Coles will no longer have direct exposure to retail fuel price movements.

Viva will pay Coles $137 million in compensation at the completion of the transaction and make a payment for net working capital upon expiry or early termination of the alliance.

Coles will receive a further payment for the convenience business upon expiry or early termination of the alliance.

Discounts to stay

Mr Cain said existing loyalty benefits will continue, including a 4¢ a litre fuel discount at all alliance sites and the ability to earn flybuys points on fuel and merchandise.

“We believe the benefits of the new agreement are compelling for all customers, team members and shareholders,” said Mr Cain, adding that the previous agreement was unsustainable and Coles had to “draw a line in the sand.”

Viva chief executive Scott Wyatt said Viva was aiming to lift alliance fuel sales back to about 70 million litres a week in the medium term and to 75 million after that, up from about 62 million at present.

“Today’s announcement signals a significant step forward in our long-standing alliance with Coles Express,” Mr Wyatt said.

Mr Errington described the deal as “a pretty solid outcome” for Viva, which will in future get both the wholesale and retail margin on petrol sales by the alliance, and pay an agent’s fee to Coles to operate the sites.

“You have now got yourself quite bit of sugar… to be able to reinvest and get the business humming again,” Mr Errington said, adding that fuel retailing competitors must be getting a bit “nervy” about the potential impact of the refreshed alliance.

The $137 million Viva is due to pay Coles represents the “value shift” taking place as a result of the reset of the deal, Mr Wyatt said.

“Together, we represent Australia’s leading fuel and convenience offer and we look forward to growing the alliance with Coles Express in the years to come.”

Coles has also pledged to match dollar-for-dollar every customer donation to Red Cross through Coles checkouts over the next two weeks to help communities affected by natural disasters, including the floods in far north Queensland and bushfires in Tasmania and Victoria.

Extracted from AFR