Will Wesfarmers Be Stronger Without Coles?

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Wesfarmers is planning to retain a 15% minority stake in Coles and 50% stake in Flybuys, ensuring the two companies are aligned in terms of digital, data and loyalty programs.

-Will Wesfarmers be a stronger business without Coles?
-New Wesfarmers may be more affected by a slowing housing cycle
-Coles may need to fund part of its dividend with debt to meet targets
 

By Eva Brocklehurst

Wesfarmers ((WES)) has reiterated its reasoning behind the proposed de-merger of Coles and has crunched more numbers, with the timetable for completing the process set for the end of November.

Shareholders will receive one Coles share for every Wesfarmers share. The company plans to retain a 15% minority stake in Coles and a 50% stake in Flybuys. This should support the alignment between the two in relation to growth initiatives in digital, data and loyalty programs.

Given the significance of these initiatives to the broader business, Morgans suspects Wesfarmers will retain its strategic holding in Coles for the longer term. By de-merging Coles, management can focus on deploying capital to better-returning businesses and free capacity to make value-accretive acquisitions.

The broker continues to believe de-merging Coles is the right move as it generates only 9% of returns on capital but consumes around 60% of capital employed by Wesfarmers. This is well below Bunnings Australasia (47%), department stores (26%), Officeworks (16%) and industrial (18%).

Wesfarmers has also announced a number of board appointments including James Graham as chairman. Coles is expected to have a dividend pay-out ratio of 80-90%, in line with Wesfarmers' current policy.

Morgans believes Wesfarmers without Coles will be a stronger business, given a bearish view on the long-term outlook for supermarkets. Yet UBS believes the outlook for Wesfarmers is challenging too, as Bunnings is affected by the weaker housing backdrop and there are consumer headwinds plaguing Kmart and Target. There is also new supply in the Western Australian ammonium nitrate market that affects the company's industrials division.

A potential catalyst, UBS asserts, is a capital management announcement at the FY18 result, due August 15. However, Citi suggests the prospects of capital management for Wesfarmers are only modest, with only 1% accretion to earnings per share from a potential buyback.

Cash conversion is likely to moderate without Coles, Ord Minnett expects, and there is a lack of valuation support for Wesfarmers. The broker finds the risk/reward no longer compelling and maintains a Lighten recommendation.

Shaw and Partners also cites speculation that the new Wesfarmers, with Bunnings taking up more than 50%, will be more affected by the slowing housing cycle, although this has always been a risk and managed well to date.

The broker, not one of the eight stockbrokers monitored daily on the FNArena database, considers Wesfarmers fairly valued with minimal growth in earnings over the next few years, and maintains a Hold rating and $46.25 target.

The most urgent question for Shaw and Partners is how Coles will fare in the face of a resurgent Woolworths ((WOW)), which is expected to maintain its lead for at least the next two quarters, along with increased competition.

On a more positive note for Coles, UBS observes recent trading has improved, based on its supplier survey. The outlook for inflation is also improving. Nevertheless, the broker suspects significant investment is needed in the supply chain and the stores. Cash conversion could fall below 100% if inventory needs to increase.

There is also some uncertainty over the future strategy, given the new CEO Steven Cain is yet to start. While the top line appears to be improving UBS expects incremental return on invested capital will be well below that of the past 10 years.

Valuation

There was nothing in the detail that changes Morgans' view. As a stand-alone entity Coles is valued on an EV basis of $17.6bn based on a 12x FY19 EV/EBIT multiple and in line with global supermarket peers.

Deutsche Bank values Coles at around $20.3bn, implying a share price of $13.90, a 9.1x EV/EBITDA ratio and an  FY19 PE of 18.2x, which indicates an -11% discount to Woolworths (adjusted for petrol). The broker expects the new Wesfarmers will trade on an FY19 PE of 18.6x and a share price of $35.50, including its 15% stake in Coles.

Gearing

Deutsche Bank is pleased that Coles will neither be over, nor under, geared and its net debt does not provide room for substantial investment price, which should make for a rational industry. Coles will also have operating lease commitments of around $9.6bn with a weighted average lease expiry of around 6.5 years.

Citi agrees the decision to have a more prudent level of debt in Coles is welcome and a higher dividend pay-out signals rational behaviour as a stand-alone entity. Nonetheless, the broker suggests Coles may need to ramp up capital expenditure and fund part of its dividend with debt in order to meet its targets.

Coles will have some capacity to invest in refurbishments, small format stores, service and other areas to drive growth in earnings but Citi suspects it will be unlikely to organically fund expenditure and dividends in FY19.

Debt levels are in line with Ord Minnett's expectations and considered prudent, given there is only modest earnings growth on offer, although free cash to fund the dividend is acknowledged to be tight. The broker considers the de-merger a positive for industry competition.

The database shows four Hold ratings and three Sell for Wesfarmers. The consensus target is $44.88, suggesting -9.1% downside to the last share price. Targets range from $42.00 (Morgan Stanley) to $47.34 (Morgans).

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