Growing Apart

Wesfarmers plans to spin off its Coles division, following a review of its portfolio and an assessment of how its capital was employed. The aim of the demerger, which is still subject to board, shareholder and regulatory approvals, is to allow management to focus on growth opportunities in its remaining businesses. Coles managing director John Durkan is to be replaced by Metcash Supermarkets CEO, Steven Cain.

 

The demerger, if approved, would occur in FY19 and is likely to be concluded in early CY19. The new Coles managing director commences in September 2018, which makes a longer time before the transaction is completed more likely.

 

We make the following observations:

  • Coles accounted for about 60% of Wesfarmers’ capital employed and 34% of divisional earnings as at the end of the first half on 31 December 2017.
  • The new entity is expected to be a top 30 company on the ASX, with mature and cash-generative assets. Businesses to be included in the Coles portfolio include a national network of 806 supermarkets as well as Coles Online; Liquorland, Vintage Cellars and First Choice Liquor; Coles Express, which operates 712 fuel and convenience store outlets; Coles Financial Services, which offers general insurance and credit cards; and Spirit Hotels, a chain of 881 hotels.
  • Wesfarmers will retain Bunnings, Kmart, Target, Officeworks and its industrials portfolio, and proposes to keep a minority interest of up to 20% in Coles following the demerger.
  • Wesfarmers shareholders are expected to receive shares in Coles proportional to their existing holdings, after taking into account any shares to be retained by Wesfarmers.

Separately, following a review of the challenges for the UK home improvement sector, we have incorporated a more pessimistic view on the Bunnings UK & Ireland (BUKI) business. In our view, Bunnings’ store profitability will not be sufficient to offset the Homebase operating losses and store closure costs. The decision to exit or retain the BUKI business is independent of the deliberations about the Coles demerger; we reiterate our view of an exit as the preferred strategy.

 

We believe Wesfarmers management is taking bold and decisive action, and the changes should provide a catalyst to drive share price performance, but further growth will be more reliant on inorganic sources. For now, we maintain our Hold recommendation on Wesfarmers, but have raised our target price to $42.50 from $40.00 in line with our discounted cash flow valuation.

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