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Wesfarmers – Was Coles worth it?

The supermarket world was in turmoil when Wesfarmers ponied up $19.6 billion back in 2007 for the Coles Group of retail companies. More accurately, it was Coles that was in trouble while Woolworths was the clear number one operator by the length of the straight. 

It has taken ten years but according to Wesfarmers, Coles is now fixed and ready to stand on its own.

The chutzpah exhibited by Wesfarmers at the time was quite impressive. The company claimed it had the retail experience and know-how to turn the stumbling Coles around. Presumably, this was based on the very successful Bunnings business acquired way back in 1987. But supermarkets, discount retail and liquor? 

The market had every reason the be sceptical but in hindsight, 2007 was a great time to be buying Coles. In portfolio manager parlance, it was a deep value asset. In layman’s terms, it was the worst house on the best street. 

The incumbent management and Board had done a stupendous job of almost running Coles into the ground as anyone who shopped at the run-down stores could have attested.

If Wesfarmers has decided now is the right time to jettison 85% of Coles and generously sell it to you, the new shareholder, should you be concerned that you are buying Coles at or near its peak in terms of valuation? 

What value has Wesfarmers left on the table for you as the new owner of a low growth supermarket in a highly competitive industry with the dawn of the Amazon era upon us? 

The ease with which Aldi was able to snaffle more than 10% of the supermarket pie is a reminder that shoppers are not loyal and are amenable to new and different offers, especially ones that are keenly priced.

Costco has set up shop in Australia too, and while it has been much slower to import its giant model, it is not the only supermarket operator still eyeing up the relatively good profit margins available in Australia. Kaufland is waiting in the wings and of course, who knows what Amazon is planning following its Whole Foods acquisition and planning to roll out 3,000 cashierless food stores by 2021 in the US.

It wasn’t only Coles that wasn’t ship shape back in 2007. Kmart was in a mess too and Wesfarmers considered flogging it to Woolworths but the ACCC saw the folly of that idea and quickly shut it down. 

Ironically, Wesfarmers considered Target to be performing strongly and had plans to aggressively expand. It worked OK for a while with EBIT peaking at $380 million in FY10, but that disappeared quicker than an ice cream at Bondi beach in January. Target reported EBIT losses in FY16 and FY17 with a small recovery last year.

It’s also instructive to look at the relative size of Bunnings at the time. In 2007, Bunnings recorded EBIT of $528 million while Coles had EBIT of $779 million in 2007.

Wesfarmers threw the kitchen sink at revitalising Coles, including some very expensive management talent and a truck load of capital expenditure totalling $9 billion since FY09. It should be acknowledged that the big capex spend was necessary not only to catch up on years of neglect but to close the gap on Woolworths in almost every aspect of the business from store layout to logistics.

Fast forward to 2018 when Coles will exit the Wesfarmers portfolio (other than the residual 15% stake) with sales close to $40 billion (including convenience) and EBIT around the $1.6 billion mark. Bunnings’ Australia and New Zealand EBIT in FY18 was just over $1.5 billion.

Using Wesfarmers’ metric of performance – return on capital – shows that the Coles business did indeed improve over the last decade from 5.5% in FY09 to 9.2% in FY18 with a peak year of 11.2% in FY16. Bunnings recorded ROC of 30.2% in FY09 and a gargantuan 49% in FY18 excluding the distraction of the UK disaster. Just for good measure, Kmart lifted its performance from 10.2% ROC in FY09 to 43.7% in FY17 (FY18 reported ROC of 32.8% including the underperforming Target Group).

It is important to understand that Wesfarmers runs its business as a portfolio and clearly doesn’t shy away from pursuing or divesting any business regardless of its industry.

In contrast, Coles is more likely to be run as a cash generating business utilising its defensive characteristics. Wesfarmers outwardly admits that the recovery in Coles earnings has been achieved and expectations for future growth are moderate.

By implication, the remaining Wesfarmers portfolio is likely to be seeking higher growth from its existing and future assets. It will be interesting to see how and when Wesfarmers decides to use its post-Coles balance sheet in light of the Bunnings UK wobble. 

Coles will be a large company in its own right with 2017 revenue around $39.2 billion, EBIT of $1.6 billion, and 109,000 employees running 2,500 stores. It will probably feature as one of the top 30 companies on the ASX. 

The ability to compare the valuation and performance of Coles to its nearest competitor, Woolworths, should be a more precise exercise.

It is important to remember that the demerged Coles Group will include the liquor division, the Coles Express network of fuel and convenience shops and the Flybuys loyalty program (Coles 50%) with an estimated 8 million active members.

Chief executive Steven Cain has already taken up his new post and has a full Board of 7 Directors ahead of the November demerger date.

We already know the balance sheet will have net debt of approximately $2 billion that will enable it to have a strong credit rating with some wriggle room. Dividend policy will mirror Wesfarmers’ practice intending to utilise all franking credits with a payout policy range of 80-90% of profits.

Keep in mind that Coles will have operating lease commitments of approximately $9.6 billion with a weighted average lease expiry of around 6.5 years.

Wesfarmers shareholders will receive one Coles share for each Wesfarmers share owned on the applicable date. The process from here still requires Board, regulatory, court and shareholder approval, all of which will occur over October and November 2018.

Demergers have a reasonable track record of success in Australia though each must stand on its own merit. At this point, prior to seeing the nitty gritty of the Scheme of Arrangement, there seems no reason to be concerned about the future of either company. 

But don’t ignore the economic environment into which Coles is being reborn.

Australia is finally seeing the air seep out of a heavily overbought residential property market, deflating consumer confidence at the same time. And last time we checked, the RBA’s inflation needle was hardly being disturbed by wage inflation even though unemployment is near historic lows.

Coles may look all shiny and revitalised, but we should all hope the share price doesn’t replicate its highly successful ‘down-down’ marketing pitch.

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