Coles to be demerged
Wesfarmers (WES) has announced its intention to demerge Coles. The decision follows a review of WES's portfolio and management's intention to target a higher capital weighting towards businesses with strong future growth prospects. For FY19, we estimate Coles represents 34% of group EBIT while Home Improvement represents 33%. Following the demerger of Coles, Home Improvement's percentage of earnings will rise substantially to 50% of group EBIT. This composition will likely change further over time as management pursues acquisitions and divestments. Following the demerger, WES intends to retain a minority stake of 20% in Coles to support strategic alignment between WES and Coles in relation to various growth initiatives such as digital and data.
The demerger is subject to final board approval, third party consents, and regulatory and shareholder approvals. If approved, the transaction is expected to be completed in FY19. In addition to the demerger, WES also announced that John Durkin (the current Managing Director of Coles) will step down and be replaced by Steven Cain.
Demerger will allow greater focus on existing businesses and M&A
Given Rob Scott's focus on return on capital (ROC) we believe the demerger makes sense. Coles generates only 9% ROC but consumes approximately 60% of WES's capital employed. This is well below Bunnings (31%), Department Stores (26%), Industrials (18%) and Officeworks (16%). By demerging Coles, management can focus on deploying capital to better returning businesses within the portfolio and free up capacity to make value accretive acquisitions.
Given our bearish view on the long term outlook for supermarket sector we think this move makes sense. Wesfarmers without Coles looks to be a stronger business that should trade on a higher multiple.
As a standalone entity we value Coles on an enterprise value of A$17.7bn based on a 12x FY19F EV/EBIT multiple, in line with global supermarket peers.
While we make no changes to earnings forecasts, we have increased our share price target (Morgans clients can login to view). The increase in our target price is based on a roll forward of our valuation to FY19 earnings forecasts as well as higher valuations for Home Improvement and Officeworks.
We believe a greater focus on the existing higher returning businesses should lead to improved growth prospects, but retain our Hold recommendation.
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