Article rating: 5/5

On Friday, Wesfarmers Ltd (WES) announced its intention to demerge Coles into a separate ASX-listed entity. Click here to view the presentation.

Key points:

  • The decision emerged as a result of management’s “thorough” review of WES’ portfolio and capital allocation.
  • As at 31 December 2017, Coles made up 60% of WES’ capital employed and 34% of group earnings.
  • The demerged Coles entity will be an ASX-30 listed company. Steven Cain will be the next MD of Coles, with John Durkan stepping down. Steven was part of the original Coles acquisition team.
  • WES’ shareholders will receive new shares in Coles proportional to their existing shareholding.
  • WES will retain a minority interest (up to 20%) in Coles and “a substantial” ownership stake in flybuys.
  • Given the mature earnings profile of Coles, management would like to reallocate this capital towards businesses with strong future earnings growth prospects – “pursuit value accretive transactions”
  • As per normal demerger is subject shareholder and other approvals.
  • Further information about the demerger “will be provided in due course” but if approved expected to be completed in FY19.

Wesfarmers & Coles post the proposed transactio

Our view?

WES’ is one of the few conglomerates we know who has been successful at operating the “portfolio of companies” approach to creating shareholder value. At the end of the day, management’s job is to continue turning the portfolio of companies and introducing new growth opportunities. Without any doubt, the Coles investment has been a very successful one – probably one that most were very sceptical given the investment size. However, the turnaround of the business is complete, asset is mature and, as management have pointed out, taking up a significant amount of capital employed. We think the decision is the right one.

Why keep a 20% stake?

We must admit we are not entirely sure why WES is retaining a 20% stake. It is not a natural owner of these types of equity interests. We agree with concerns raised whether this transaction is an exercise of freeing up capital on WES’ balance sheet but still keeping an hand in the pie, so to speak.

What does this mean for valuation?

At the end of the day this is what it all comes down to – how (and if) does it change the valuation. A sum-of-the-parts (SoTP) valuation of WES is provided in the figure below. Clearly there is a disconnect between current share price and what most in the industry refer to as break-up value. We suspect the Board of WES is also thinking about this and looking to close the gap. The share price is up +5.95% at the time of writing.

Key points from analysts’ Q&A.

  • Disruptions impact. Company expect minimal disruption from change in management team at Coles during this transition period. Outgoing MD’s KPIs are aligned to ensure ongoing momentum in Coles.
  • Balance sheet impact. While no specific details were provided, Coles is expected to retain investment grade ratings (BBB / BBB+), this suggests fixed charge cover target of 2.6x.
  • Dividend policy. No specific guidance on dividend as yet but intention is to maintain current dividend.
  • Earnings outlook. Management will provide more disclosure around Coles in due course and may include earnings outlook/guidance.
  • Bunnings. Management noted that the demerger of Coles will have the most impact for WES’ group valuation hence why it was considered. Bunnings is already valued appropriately by the market. Still see earnings growth in Bunnings in Australia and NZ, so happy to hold. Plus issues in the UK means not the right time to consider such a transaction for this asset.
  • Trade sale vs. demerger. Whilst the Company is happy to consider a trade sale for Coles (if an extremely compelling price is offered), it is management’s view that a demerger is better for shareholders.
  • Capital management. Post demerger, management noted that if the Company has surplus capital and no investment opportunities (organic or inorganic) then they will consider capital management initiatives.