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Morningstar | Corporate Action: Pour on the Coles and Vote in Favour of Wesfarmers' Proposed Demerger

We recommend that Wesfarmers shareholder vote FOR the proposed resolution at the scheme meeting on Nov. 15, 2018, to separate Coles from the group.

Narrow-moat-rated Wesfarmers' management is suggesting a material restructure of the group with the demerger of Coles, separating the second-largest Australian food and liquor retailer from the core Bunnings home improvement retail stores. The two businesses account for about two thirds of group EBIT and have very different investment characteristics.

The proposed demerger has little impact on our unchanged AUD 39 fair value estimate for the combined group, yet Wesfarmers shares have been elevated since the initial announcement in March. We reiterate our view that it is unlikely cash flows generated by the existing businesses are enhanced by simply splitting them apart, and we can't see a material value uplift from doing so. However, while other merits for the demerger arguably exist, our chief reason for voting in favour of the restructure is avoiding a potential derating of the share price, which has been buoyed significantly above our fair value estimate since the transaction was announced.

By separating the two largest businesses of the conglomerate, management argues that investors have a clearer choice between growth-focused versus higher-dividend-yielding investment propositions and could fine-tune their risk exposure according to their appetite. The Bunnings home improvement chain is highly profitable and is growing rapidly, but it is exposed to a fundamentally cyclical Australian housing market. Slow-growing Coles supermarkets’ operating cash flows are more defensive but are facing fierce competition, most recently manifested in deteriorating EBIT margins in food to 3.9% in fiscal 2018 from 5.2% only two years prior.

Coles expects to institute a payout ratio of 80%-90% of earnings, markedly higher than the 75% we forecast for Woolworths, but the relatively high payout ratio also highlights the lack of organic growth opportunities in the mature Australian grocery market.

Although Wesfarmers’ pro forma gearing will increase slightly to 17% post-demerger from 16% for the combined group in fiscal 2018, we expect Wesfarmers to maintain its investment-grade credit rating, leaving the group with ample firepower to pursue acquisitive growth opportunities. At only about two thirds the size of Wesfarmers today, even smaller acquisitions could still make a meaningful impact to the group’s earnings profile. In the absence of such an acquisition, we anticipate share buybacks or special dividends to delight shareholders in Wesfarmers post-demerger.

But we also see negatives in the demerger that offset some of these benefits. These downsides include one-off transaction costs, which are estimated at AUD 148 million, pretax, and ongoing additional stand-alone expenses of AUD 28 million per year arising from corporate staff and board salaries, as well as ASX and auditing fees.

Wesfarmers didn’t relate any earth-shattering news with the release of the Coles Demerger Scheme Booklet, and Coles’ new management is largely committed to the existing strategy. However, the EBIT margin split between Coles’ three individual businesses--supermarkets, liquor, and convenience--were disclosed. The supermarkets segment, accounting for about 80% of Coles’ revenue and operating profits, has seen EBIT margins stabilise at around 4% over the past two years, a level we forecast to be sustainable in the long term.

We will publish a detailed research report on Coles before shares commence trading on the ASX on a deferred basis from Nov. 21, 2018, assuming the demerger goes ahead as we expect. Our preliminary DCF-based fair value estimate range for Coles is AUD 14.50-AUD 16.50, but is subject to the final determination of the Morningstar moat rating, potential changes to our cash flow projections and assumed investment expenditures for Coles, and interim company announcements such as the upcoming quarterly sales update on Oct. 15, 2018.