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What Future For Wesfarmers Without Coles?

Australia | Mar 19 2018

This story features WESFARMERS LIMITED, and other companies. For more info SHARE ANALYSIS: WES

Wesfarmers will break with its supermarkets business, Coles, listing it on ASX while retaining a stake, a move largely welcomed by brokers.

-Retention of 20% could be a source of capital for future growth
-Subsequently, Wesfarmers would generate over 80% of earnings from non-food retailing
-Coles likely to appeal to defensive investors with need for stable long-term returns

 

By Eva Brocklehurst

In order to pursue higher returns from remaining businesses and open up opportunities, the Wesfarmers ((WES)) conglomerate will de-merge its Coles supermarkets. Coles will become a separate entity, to be listed on ASX, subject to regulatory and shareholder approvals.

Coles represents around 34% of Wesfarmers' earnings and, once a leader for the company, is now slotted in behind Bunnings Australasia. Wesfarmers intends to retain a 20% interest in Coles and will be targeting a strong investment-grade credit rating.

The de-merger makes sense to Morgans, given the long-term structural headwinds in the supermarket sector, while it frees up Wesfarmers to invest in higher returning businesses, or pursue acquisition opportunities.

Macquarie points out the limited vote risk is a good idea, as Wesfarmers will not escrow the 20% stake, and this could be a source of capital for future growth. If supported, the de-merger should be completed in FY19.

Following the de-merger, and assuming completion of the Curragh sale, Morgan Stanley estimates that in FY19, 55% of earnings will be generated from Bunnings (currently circa 33%), 22% from Kmart/Target, 17% from industrial business and 6% from Officeworks, which means Wesfarmers will generate over 80% of its earnings from non-food retailing.

It should also become easier to value the remaining parts of Wesfarmers, although Shaw and Partners warns that for every successful de-merger, e.g. Amcor ((AMC))/Orora ((ORA)), there is also a poor one, e.g. Toll Holding/Virgin Australia ((VAH)).

Credit Suisse speculates that the defensive rationale for the ownership of Kmart and Target will disappear with the de-merger of Coles, expanding the opportunity for Wesfarmers to own more department stores.

The decision signals to Deutsche Bank that new management is taking an active approach to managing the portfolio and Coles will be better placed to succeed in the long-term outside of Wesfarmers, while in the short-to-medium term the company be more considerate of industry profitability.

Ord Minnett suggests that while the company is seeking to access higher growth, this is not evident in its existing operations and acquisitions may be required and, indeed, appear more likely with the de-merger. Wesfarmers may become a higher-multiple business, excluding Coles, but the expansion opportunity is considered modest.

Supermarket Segment

The announcement is good news for Woolworths ((WOW)), in Deutsche Bank's opinion, as in the short term the disruption from management changes at Wesfarmers and the de-merger process for Coles could enable Woolworths to extend its leadership in sales growth.

Moreover, Coles will have far less ability to be aggressive on price and so the industry is is likely to be more rational. The broker acknowledges that this dynamic could extend to Metcash ((MTS)) but this may be offset by a loss of talent, as its supermarkets CEO, Steven Cain, will depart to head up Coles.

Credit Suisse agrees that as Coles moves out from under Wesfarmers funding, supermarket industry rationality should improve.

The turnaround of Coles is finished and growth will be more elusive, in Morgan Stanley's view. Since acquisition in 2007, Wesfarmers has sold the Coles credit card business and released around $850m in working capital.

The broker considers Coles a relatively low growth company that faces increase competition from both Woolworths and discounters, and does not believe separating Coles will drive either accountability or performance, maintaining an Underweight rating on Wesfarmers.

Bunnings UK & Ireland

Credit Suisse suggests, although these are independent decisions, the emergence of a slimmed down Wesfarmers could increase the likelihood the company cuts loose the underperforming Bunnings UK business, which would also be greeted positively by the market.

Ord Minnett also reiterates a view that an exit of the UK business for Bunnings is a preferred strategy. The broker considers much of the potential upside is factored into the stock and therefore maintains a Hold rating.

Macquarie, on the other hand, suspects closure of Bunnings UK is now less likely although had hoped it would occur. The broker believes Wesfarmers would be an attractive business without Coles, and still considers the share price is under appreciating the Bunnings business.

With a smaller profit base in each business, the broker also believes strategic initiatives will be more material to earnings, also a positive. Coles will probably appeal to more defensive investors that are interested in stable returns over time.

Leases & Debt

The structure of leases should provide no material issues, Shaw and Partners suggests, and Coles will continue to develop its property portfolio, with the majority of stores leasehold. The broker, not one of the eight monitored daily on the FNArena database has a Hold rating and $43.50 target.

Deutsche Bank notes, as is the case with all retailers, lease obligations have more of a bearing on credit metrics than the level of debt, particularly in a low interest rate environment. The broker believes the annual lease expense for Coles, while not disclosed, is around $1.25bn, which suggests Coles could feasibly accommodate $1-2bn in debt.

Macquarie believes it makes sense for Coles to carry more debt, given it generates substantial cash and is more stable. The broker estimates that the Wesfarmers business, without Coles, has $4bn in balance-sheet capacity which could be 5% accretive if $2bn is deployed.

Despite the problems with Bunnings UK, the broker suggests the group is keen to buy more business. Macquarie has held a view for some time that there is hidden value in Wesfarmers and maintains an Outperform rating.

FNArena's database shows two Buy ratings (Macquarie, Credit Suisse) five Hold and one Sell (Morgan Stanley). The consensus target is $43.06, signalling -0.4% downside to the last share price. This compares with $41.85 ahead of the announcement.

Targets range from $40.00 (Deutsche Bank, Morgan Stanley) to $50.03 (Macquarie). The dividend yield on FY18 and FY19 forecasts is 5.0% and 5.1% respectively.

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