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The Experts

Is Coles a sell?

Paul Rickard
Friday, November 23, 2018

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530,915 Australians are now direct shareholders in supermarket chain Coles, following its demerger from Wesfarmers, making it one of Australia’s most widely held companies. It will also have one of the most inverted share registers, with a massive 97.2% of shareholders owning less than 5,000 shares each and the top 0.02% of shareholders owning 63.6% of the total number of shares on issue.

The question that shareholders in the newly ASX-listed Coles (COL) will be asking is: what do I do with my Coles shares? Sell, buy more, or hold?

Strategically, many will look at the supermarket industry and say that there are enough headwinds – competition from discount supermarket operators, such as Aldi, Costco and Kaufland; margin pressure from customers and suppliers; the threat of the Amazon juggernaut – to give this company the flick. And that’s without even considering the impact a refreshed Woolworths or IGA can make. Sure, Coles will pay a handy dividend, but this is a low growth, low margin, increasingly competitive industry.  The facts speak for themselves, with Coles EBIT (earnings before interest and taxes) declining from $1,779m in FY16 to $1,522m in FY17 to $1,414m in FY18. The Coles investment thesis  is not compelling.

Others will look at the history of demerged companies and say that over the medium term, they usually perform pretty well. Think S32 from BHP, Orora from Amcor, CYBG from NAB, Pendal from Westpac, BlueScope (eventually) from BHP, Dulux from Orica and Treasury Wine Estates from Fosters.

Why these have worked is hard to say. One theory is that “big isn’t always better” and that a refreshed management team removed from the bureaucracy and constraints of “head office” is set free to thrive. But there have also been a couple of disasters – PaperlinX from Amcor and OneSteel (later called Arrium) from BHP readily come to mind – so it’s not a lay down misere.

On reflection, it is hard to see how Coles fits the bill of a typical demerged company. It hasn’t been starved of capital (it accounted for about 60% of Wesfarmers capital), nor has it been the “unloved child”. And as a conglomerate used to owning and managing disparate business, ranging from department stores to fertiliser production to mining, Wesfarmers “head office touch” has always been relatively light.

And that brings us to valuation. Although some analysts are still crunching their numbers, broker consensus for Coles is for forecast earnings in the range of 65 to 75 cents per share. Based on last night’s closing price of $12.75 per share, this puts Coles on a multiple of 17.0 – 19.6 times FY19 earnings. Its competitor, Woolworths, is trading of a multiple of 21.2 times forecast FY19 earnings and 20.2  times FY20 earnings.

Given that most analysts expect Coles to trade at a discount to Woolworths, Coles looks fairly priced. However, the history of demergers is that newly demerged companies tend to struggle on the market for the first six months or so because of the supply overhang, before finding a level that attracts fresh buyers.

Bottom line – Coles is a sell.

There may be a case for owning it in an income-focused portfolio, but at a more attractive price.

What is the future for Wesfarmers?

Under MD Rob Scott, Wesfarmers has been employing the old “shrink to greatness” strategy. Since taking over, he has divested their disastrous investment in Homebase, the chain of UK home improvement stores that Wesfarmers tried to “Bunningsise” and failed so dismally. He has completed the demerger of Coles, exited coal mining with the sale of the Curragh mine and a 40% interest in the Bengalla JV thermal coal mine, sold the Kmart Tyre and Autoservice business and disposed of a 13.2% indirect interest in Quadrant Energy.

To be fair to Scott, this has been about repositioning the conglomerate for the future so that it is focused on higher growth, higher returning businesses. The balance sheet has been considerably strengthened and on the whole, the market has welcomed the sales.

But he hasn’t yet created a single dollar of new revenue. The absurdity of the share price going up to almost $53.00 on the news that Coles was being demerged and completion of other corporate actions has been laid bare by the post-demerger aggregated share price today of $44.71 (Coles of $12.75 and Wesfarmers of $31.96). A fall of 15.3%.

In terms of the existing Wesfarmers businesses, Bunnings seems to go from strength to strength. However. a challenged housing market could impact sales growth. Kmart is on fire, while Target continues to struggle. Officeworks has probably been squeezed as hard as it can (Wesfarmers tried to IPO this but failed), and measured growth is the best that can be expected from the industrials and safety division.

The bottom line is that the jury is out on Wesfarmers. According to FN Arena, of the 8 major broking firms that cover the stock, 5 have neutral recommendations, 1 rates it as a sell and two firms have no rating. Like the market, they want to see what Scott is going to do with Wesfarmers. Selling assets was the easy part – the hard work, to build and develop new revenue streams, awaits.

Wesfarmers is a hold.

Published: Friday, November 23, 2018

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