The critical factor in the Coles demerger

On Friday, Wesfarmers announced an intention to demerge their Coles Food, Liquor and Convenience business. While this transaction has some attractive merits we also have some reservations and argue more information is required. How much of the current group’s debt Wesfarmers allocates to Coles vs retaining in the rump will be critical to the future of the new vehicles, the shutting down Bunnings UK and Ireland (BUKI) and their ability to do deals.

Actively managing assets

Wesfarmers has received some criticism in the past for accumulating businesses – as opposed to actively managing its portfolio of investments. The size of Coles within the group meant that it was hard to find transactions that materially moved the dial.

But this transaction will be the second in the recent history of the new management team lead by CEO Rob Scott – the first being the sale of their Curragh coal mine.

The remaining Wesfarmers unit will have just 40% of the previous total capital employed. This remaining vehicle may on the face of it appear much smaller and nimbler.

Coles likely to be less price aggressive

Wesfarmers’ management today argued that have delivered a world-class retail transformation at Coles with EBIT having grown 9.5% cagr since FY09.

But there is arguably much more to do. Coles 1H18 EBIT margin was just 4.0%, which compares to Woolworths at 5.1%.

If it was all going so well right now, we’d question why there was the change of management, with Coles Managing Director of 10 years, John Durkin departing and being replaced by Steven Cain from Metcash.

Coles as a standalone may perhaps be less price aggressive going forward – without the balance sheet support of broader Wesfarmers and to maximize short-term profits in the hope of a higher valuation multiple – and that would be a positive for all industry players.

Debt allocation will be critical

At Paradice Investment Management we consider the debt leverage on the balance sheet as one factor that is critical to a company’s ability to prosper.

As at 31 December 2017 Wesfarmers had $3.9b of net debt.

The issue now is that this pile of debt must be allocated somewhere – it must be split between the Coles spin out and the remaining Wesfarmers rump. How it gets allocated will determine the balance sheet health of each entity and therefore that vehicle’s ability to prosper.

Coles have substantial lease liabilities that will inhibit its ability to take on too much of the debt.

The Wesfarmers rump will own Bunnings including the problematic BUKI unit and so be left with the decision of whether to close the latter or not. This will not be a decision management will take lightly as they spent A$700m buying Homebase and have invested many millions more starting to convert some stores into the Bunnings format. But in the 1H18 the unit lost A$165m in Earnings before Interest and Tax (EBIT). Management have said that they will review the investment and update the market in June 2018.

If the Wesfarmers rump decides to shut BUKI the entity will need to have substantial debt capacity to shut the vehicle down – pay our lease liabilities, redundancies etc. Wesfarmers disclosed on their 1H18 earnings conference call that BUKI had GBP1b of lease liabilities. Some of this will of course be able to be defrayed.

The Wesfarmers rump going forward will also need to be relatively under levered if it is to be perceived as a vehicle that can then potentially pursue new attractive deals.

Conclusion

At Paradice Investment Management we will next look at the debt allocation as this will determine the ability of Coles to continue to invest in price, and the ability of the rump to shut BUKI and embark on further deals.

For further insights from the Australian Large Cap team at Paradice Investment Management, please visit our website