It always pays to be wary when the price of a stock jumps suddenly following 'news'. Particularly when that news has absolutely nothing to do with value creation. This is exactly what happened to Wesfarmers last Friday.
On the back of an announcement that Wesfarmers is set to demerge the Coles business (supermarkets, liquor stores and convenience stores), its shares jumped by 6.3% from $41.20 to $43.80. In market capitalisation terms, it added (“wiped on”) a staggering $3bn.
But no new value has been created. Not a single dollar of earnings has been made. All that has happened is the development of a plan for Wesfarmers shareholders to exchange a share in the current business for a share in Coles and a share in a new Wesfarmers (ex Coles). Purely a paper transaction.
And because there will be costs to implement this plan (stamp duty, legal fees, advisers fees etc), Wesfarmers shareholders in aggregate will be poorer initially.
That doesn’t mean that the plan isn’t without merit, and that it won’t ultimately be a positive in the long run for shareholders. Recent demergers, such as S32 and CYBG, have done reasonably well once the initial overhang of stock has been cleared (typically, this takes about 6 months). However, the proof will ultimately be in the delivery, rather than the expectation. This is one of the reasons that Wesfarmers shares have eased this week, pulling back to $43.05 yesterday as saner heads prevailed.
Rationale for the demerger
Wesfarmers rationale for the demerger is pretty straightforward. It reckons that Coles is impacting its return on capital. Coles contributes 34% of the conglomerate’s EBIT, but employs 61% of the capital. By getting rid of Coles, the return on capital employed for the new Wesfarmers will be a lot higher.
Wesfarmers will also be in a position to focus on organic growth opportunities with the remainder of its portfolio (Bunnings, Kmart, Target, Office Works and Industrials), and acquire new businesses.
Further, a newly established company comprising supermarkets, liquor and convenience stores will prove attractive to investors who want predictable and resilient earnings. Investors will pay for the defensive characteristics of the Coles business.
The sum of the parts will be greater than the whole.
As one of Australia’s last real conglomerates, Wesfarmers has a multi-decade history of active portfolio management – acquiring and disposing of businesses – and so a rationale based on improving its return on capital employed is credible. This is also borne out by the history of demergers in Australia, which in the main, have been largely successful. In addition to CYBG and S32, names such Treasury Wine Estates, Bluescope, Dulux, Orora and BT Investment Management come to mind. Maybe it is a result of “freed up/refreshed” management making the difference – big isn’t always better.
But the surviving company doesn’t always fare so well, and the Wesfarmers mergers and acquisitions team will need to take a cold shower and be careful about blowing money on new acquisitions. Their recent track record on this front is pretty poor. The disaster of the Homebase stores acquisition in the UK, which within two years of announcement has been written down to zero, comes to mind. And if you care to go back a little further, a case can be made that the acquisition of the whole Coles group in 2007 has delivered less than stellar results for shareholders.
What do the brokers say
According to FN Arena, the major brokers are largely positive on the proposal. That said, only one of the brokers upped their target price, with Morgans arguing that “a greater focus on existing businesses should lead to improved growth prospects” and raising their target from $41.18 to $44.65.
Morgan Stanley, which has an underweight call on the stock, maintained its target price of $40.00. It said that “it does not believe a separate Coles will drive accountability or performance, and incremental costs of $10-$20m should be expected as Coles operates as a separate entity”.
The consensus target price is currently $43.06, fractionally above yesterday’s closing price of $43.05. There are 2 buy, 5 neutral and 1 sell recommendation as shown in the following table.
Wesfarmers has traded in an incredibly narrow trading range over the last five years (see chart below). Essentially, it has been a buy around $37 and a sell around $44. Time spent below or above these levels has been fleeting.
While I think the demerger should be good for the company, Wesfarmers has blotted its copy book over the last few years. It allowed Woolworths to crawl back and take the lead in the super-market wars, and its foray into the UK hardware/homewares market through Homebase has been a disaster. Although Rob Scott has recently come on board as CEO and is a “cleanskin”, I get nervous when he starts talking about “value accretive transactions”.
I have been a supporter of Wesfarmers on grounds that it is better value than Woolworths (it is g on a multiple of 18.5 times forecast earnings compared to Woolworths 21.5 times), it has the powerhouse of Bunnings Australia and I think there is value in the conglomerate moderate. However, the market looks to me that it has been a little premature in subscribing value to the proposed transaction. Wesfarmers is more of a sell than a buy at these levels.
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