The demerger: Does it deliver?

On Friday, October 5, Wesfarmers released over 200 pages of documents related to its proposed $20 billion demerger of Coles, after the Supreme Court of Western Australia ordered a shareholder vote on the matter.

If shareholders approve the plan, which is also subject to court and regulatory approvals, Coles will commence trading as one the 30 largest listed companies in Australia on November 21.

The documents revealed several key pillars that Coles said would position the business for success over the next decade, including a focus on fresh food and own brand products, continued investment in everyday low prices, growth of online and click and collect offers and more tailored stores based on data.

Coles also revealed an agreement with Witron Australia, a subsidiary of Witron Logistik + Informatik, to develop two new automated distribution centres (DCs) in Queensland and NSW over the next five years.

The documents did not state how much the DCs would cost to build, though Coles said its capital expenditure guidance of $600-800 million for FY19 includes the project and it would recognise provisions of $130-150 million due to redundancies and lease exits resulting from a handful of soon-to-be obsolete DCs.

Nevertheless, analysts have jumped on the approximated cost of the DCs as a potential financial bottleneck for the new company. Bank of America Merrill Lynch analyst David Errington said spending on the DCs could surpass $1 billion and would make it difficult for Coles to deliver on its target dividend payout ratio of 80-90 per cent.

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In a note to investors, Citi analyst Bryan Raymond said that the significant investment in Coles’ supply chain, combined with its lower-than-expected cash conversion, would limit its ability to reinvest in price, service and store network, the exact areas where the supermarket is looking to compete.

At the same time, however, analysts said that the infrastructure upgrade was necessary, since Coles had fallen behind Woolworths, which is set to open a new $350 million DC in Dandenong South, Victoria, early next year.

The new DCs are expected to significantly reduce Coles’ cost per carton and improve in-store operations, such as restocking supermarket shelves.

“This should generate efficiencies, but not until the sites are opened in three to four years,” Raymond said.

Another sticking point for analysts was the $3.9 million sign-on bonus, $2.1 million base salary and various long- and short-term incentives, totalling up to $10 million – all in cash – that Coles’ newly appointed chief executive Steven Cain could take home.

The demerger documents revealed that Coles has a bank facility of $4 billion, but has only tapped $1.9 billion so far, leading some analysts to suspect that it will draw on this debt to continue investing in the business, while keeping its promise to shareholders.

Positive momentum

The documents also revealed that Coles supermarkets, liquor stores and convenience outlets reported $39.3 billion in revenue and $1.4 billion in earnings before interest and tax in FY18 on a pro-forma basis.

The company had 112,000 employees, 809 supermarkets, 899 liquor stores, 88 hotels and 711 convenience outlets at June 30, 2018, making it one of the top 30 companies in the country. About 80
per cent of Australians live within 10 minutes of a Coles store.

But while the company has recorded 43 quarters of consecutive like-for-like food and liquor sales growth, earnings declined in FY17 and the first half of FY18, due to a price war with Woolworths, lower convenience earnings and higher team member costs following a new enterprise agreement.

Coles returned to modest earnings growth in the second half of FY18, but higher wholesale fuel prices are expected to continue to crimp margins in the convenience business.

In contrast, Coles’ liquor business, including Liquorland and Vintage Cellars, has steadily improved since FY16, with revenue rising at a CAGR of 2.3 per cent on a pro-forma basis, and earnings before interest and tax rising at a CAGR of 14 per cent.

But analysts do not think the current positive momentum will be enough to see a post-demerger Coles overtake Woolworths.

“A demerged Coles is likely to be more capital intensive due to the investment in supply chain and remain rational due to the constraints of an 80-90 per cent payout ratio and cash conversion
less appealing than we initially expected,” Raymond said.

“Woolworths has reinvested a significant portion of its gains over the first two years of the turnaround. This has dampened operating leverage, but leaves Woolworths well placed to capitalise on Coles needing to catch-up on its investment in supply chain, store refurbishments, service and data.”

Shareholders will vote on the demerger proposal on November 15. If approved, they will receive one Coles share for every Wesfarmers share held at the demerger date. Wesfarmers will retain a 15 per cent stake in Coles and a 50 per cent stake in Flybuys.

Wesfarmers chairman Michael Chaney confirmed on Friday that the company’s directors intend to vote in favour of the demerger and unanimously recommend shareholders to do the same. An independent expert engaged by the Wesfarmers board, Grant Samuel & Associates has concluded the demerger is in the best interests of shareholders.

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