Wesfarmers demerger: What you need to know

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Coles has been demerged from Wesfarmers. What does this mean for shareholders, and is it worth holding onto Coles and/or Wesfarmers?

Key Points of the Wesfarmers demerger

  • Coles (ASX:COL) listed on the ASX on 21 November 2018 after being demerged from Wesfarmers (ASX:WES).
  • Wesfarmers plan on keeping a 15 per cent minority ownership of Coles and 50 per cent stake in FlyBuys.
  • Shareholders received 1 Coles share for every share held in Wesfarmers.
  • Dividends to be declared for Coles and Wesfarmers for FY19 will be the same as before the demerger.
  • Wesfarmers wants to focus on growth opportunities that can attract higher future earnings growth.
  • Coles wants to focus on shareholders looking for earnings growth with defensive characteristics.

Pros and cons of holding onto Coles

Now that COL is listed, is it worth holding onto the shares?

Pros

  • Coles has strong cash generation, a good dividend ratio, and a strong balance sheet.
  • Coles will become a defensive shareholding as groceries have consistent sales throughout all economic cycles.
  • At time of writing, some of the major analyst reports are yet to come through but for the moment, the average broker target for Coles is $13.24.

Cons

  • Coles will need to reinvest to drive sales growth. However, there may be limited motivation for that. This is because the Coles management’s incentives are driven by EBIT, return on capital, and total shareholders return, rather than sales.
  • Australians have now become accustomed to lower prices so hiking groceries prices is getting much harder for retailers. Coles is also competing against Aldi, and Amazon could one day offer Amazon fresh stores here in Australia.

Pros and cons of Wesfarmers

WES is now a very different company without Coles. Does it still make a good investment?

Pros

  • Wesfarmers will focus on four divisions. Namely:Wesfarmers
    • Bunnings
    • Kmart/Target
    • Officeworks
    • Wesfarmers Chemicals Energy and Fertiliser/Wesfarmers Industrial and Safety.
  • The Company wants to focus on earnings growth and strong cash generation.
  • With the completion of the demerger, Wesfarmers now has $500 million net debt on the balance sheet which will give the Company more flexibility to make acquisitions.
  • At time of writing, Macquarie has put a 12-month target of $36.51 for Wesfarmers, with other analysts to follow.

Cons

  • Before the demerger, Citi advised a valuation down at $28.80 per share. This price reflects the low growth nature of the continuing business and exposure of the downturn of the housing cycle. Softer growth from a slowing housing cycle is also expected to impact Bunnings. They also believe that Kmart has reach peak margins.
  • There is also an expectation that Officeworks will face pressure from Amazon as it enters the Australian market. Target stores will also contend with lower sales productivity. Kmart will need to offset gross margin headwinds from price investment.

Our View

  • Coles is a mature business and it is expected to generate reliable dividends. However, there are competitive pressures which means that it could be lucky to maintain its current share price over time.
  • WES needs to grow, and they need to make an appropriate acquisition to help get that growth. There is a risk that they are unable to find a suitable target to acquire and organic growth from their existing businesses may be hard to find.

 

Current share prices available here.

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Michael Gable is managing director of Fairmont Equities.

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