The Take

Coles and Wesfarmers Do the Splits19/04/18

QUTEFS’ Publications Officer Heath Gabbett discusses the recent plans to split off Coles from its parent company Wesfarmers, in this week’s edition of The Take:

Retail conglomerate Wesfarmers announced in late March that it plans to spin off Coles into a separate company. This decision will ultimately be impactful on the futures of both Wesfarmers and Coles, but may also change the landscape that competitors such as Woolworths operate in. This article will discuss why Wesfarmers made the decision, and what impacts the move is likely to have on the big players involved.

Wesfarmers is one of the biggest companies in Australia, made up of several divisions such as Bunnings, Kmart, Target and Officeworks. When Coles is separately listed, it is likely to be one of the 30 largest companies in that nation as analysts from both Credit Suisse and Citi value the company at around $18 billion. This move will undoubtedly take millions from Wesfarmers’ revenue, and take a big chunk out of the company’s $47 billion market capitalisation. However, analysts suggest the demerger will benefit Wesfarmers.

A big factor behind Wesfarmers’ decision to demerge Coles was that the supermarket is very capital intensive. The Coles group accounts for about 60% of Wesfarmers’ invested capital, but returns only about 34% of its earnings. In other words, the remaining divisions of Wesfarmers are able to generate greater income whilst taking up much less capital. Beyond this, the managing director of Wesfarmers also indicated that Coles had grown to a scale where it could be owned and operated separately.

While Wesfarmers seems set to benefit from the spinoff, analysts have been much more sceptical about what it means for Coles. Without the support of Wesfarmers, Coles may no longer have the access to capital it needs to grow, refurbish stores, and fund any price competition with Woolworths. Many commentators predict that Woolworths may use this period of instability to launch another round of price cutting and gain an edge on Coles. For this reason, Coles is predicted to trade at a 20% discount to Woolworths, with shares likely to be priced at a Price-Earnings ratio of around 17 – compared to the ratio of 22.75 Woolworths currently trades at. A big reason for this comparative disadvantage with Woolworths is the level of diversification between the two giants. While Coles’ demerger will include all 806 Coles supermarkets, the Coles Online sales website, 894 Liquorland stores, Vintage Cellars and First Choice Liquor, 712 Coles Express stores, Coles Financial Services and the chain of 88 Spirit Hotels – Woolworths still remains substantially more diversified. 90% of the new Coles’ revenue will come from its grocery business, compared to just 80% for Woolworths. Ultimately, due to the disruption the demerger causes, the reduced access to capital and the opportunities for Woolworths to flex its diversification, the demerger appears to be harmful to Coles.

Overall the Coles and Wesfarmers demerger seems to be an interesting move for all parties involved. Wesfarmers will benefit by freeing up some capital, Woolworths will try to take advantage of the changed competitive landscape, while Coles will be left to battle through a new capital and corporate structure. The demerger is expected to be finalised in the 2019 financial year, so it may be some time until we can see the full impact it has on these businesses.