The coles demerger – how to play it

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Demergers have had a pretty good track record in Australia. 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.

This brings us to the forthcoming demerger of Coles from Wesfarmers. Should you vote in favour of the proposal, and assuming it is carried, what should you do with your Coles shares?
 

The demerger

The demerger will see Coles as a separate ASX-listed company within the top 30 by market capitalisation. Shareholders in Wesfarmers will receive one Coles share for every share held in Wesfarmers.

It is expected to qualify for demerger tax relief, meaning that there are no immediate tax issues for shareholders. For capital gains tax purposes, the cost base of your existing Wesfarmers shares will be apportioned between the Wesfarmers shares and the new Coles shares in a ratio to be advised shortly after the demerger.

Wesfarmers will retain a 15% minority interest in Coles, which will result in Coles having more shares on issue than Wesfarmers. It will also retain a 50% ownership stake in flybuys.

It is anticipated that, taken together, the dividends to be declared by Coles and Wesfarmers for FY19 will be broadly equivalent to the dividends that Wesfarmers would otherwise have declared if the demerger did not proceed (including in respect of franking).

The stated rationale for the demerger is about repositioning Wesfarmers and Coles for the next decade, delivering shareholders an investment in two companies with different investment attributes.

For the new Wesfarmers, the investment weighting and focus will shift towards businesses with higher future earnings and growth prospects, with greater flexibility and impact on total shareholder returns.

In regard to Coles, Wesfarmers says that a successful turnaround of Coles has been delivered. It says that Coles is well positioned to continue to grow and is expected to be attractive to shareholders seeking earnings growth with defensive characteristics – strong cash generation, resilient earnings, strong balance sheet and high dividend payout ratio.

The demerger doesn’t come without costs. Wesfarmers will incur one-off transaction costs of approximately $148 million (of which $65 million has already been spent ahead of the vote), Coles will incur one-off separation costs of $25 million and on an on-going basis, running costs as a separately listed company in the order of $28 million per annum.

There is also the somewhat “half-pregnant” position of the Wesfarmers Board wanting to retain a 15% interest in Coles. It argues that this is to “support strategic alignment between the two companies in relation to various growth initiatives, including in the areas of data, digital and loyalty.” I am not sure why this requires equity to achieve this objective. It sounds more to me that Wesfarmers wants to exert some ongoing degree of influence on Coles.

Shareholders get to vote on 15 November, with two proposals to be approved. Firstly, to approve a capital reduction if the scheme proceeds and then to approve the scheme to implement the demerger. The Wesfarmers Board, supported by an expert opinion from Grant Samuel, has unanimously recommended that the demerger be supported.

By all means, wade through the 243 page Scheme Booklet, make up your own mind, and vote. But, as far as the market is concerned, this is a “done deal” and the demerger will go ahead.

New Coles shares will commence trading on the ASX on Wednesday 21 November. The last day of “cum the Coles entitlement” trading in Wesfarmers shares will be Tuesday 20 November.

Small shareholders (those set to receive 160 or fewer Coles shares under the demerger) can also elect to use a sale facility to sell their Coles shares free of brokerage. Elections for this must be received by the registry by 2:00pm (Perth time) on Tuesday 20 November.
 

The new Coles

Coles is a $1.4 billion EBIT business with sales of $39 billion, 2,500 stores, 112,000 staff and a market share in food of 31%. The new Coles will be organised into three divisions – supermarkets (80% share of EBIT), liquor (9% share of EBIT) and convenience stores (9% share of EBIT). It also owns 50% of flybuys.

The “supermarket wars” have taken their toll on Coles, with EBIT declining from $1,779 million in FY16 to $1,522 million in FY17 to $1,414 million in FY18. Coles notes, however, that second half EBIT in FY18 was up 3% on the corresponding half in FY17.

Going forward, the Coles team under CEO Steven Cain says that its “customer-led” strategy will drive customer experience and shareholder returns. For supermarkets, this means transforming the food offer, continuing the move to “everyday low prices”, an omni-channel strategy including Coles online to support “offer anytime, anywhere shopping”, store tailoring to “land the right offer in every location” and reducing costs. For liquor, this means expansion and optimisation of the store network, while continued emphasis on innovation with “food-to-go” and a trial of a fresh product offering will support convenience.

The Coles balance sheet will take on $1,905 million of gross debt and will have financing facilities in place totalling just on $4 billion. Net capital expenditure is forecast to rise from $549 million in FY18 and $558 million in FY17 to $600 million to $800 million in FY19. This includes the first year costs of the more than $1 billion in total costs of building, over the next five years, two new automated ambient distribution centres. Coles will also recognise provisions of approximately $150 million in FY19 relating to the closure of existing facilities, including lease exit costs and staff redundancies.

While Coles investment in the supply chain is expected to deliver significant productivity improvements over the medium term, news of it came as a bit of a shock to some analysts and investors, who suggested that Wesfarmers was trying to push the cost onto Coles investors. Notwithstanding the increased capex, Coles says that its strong cash generation will allow it to target a dividend payout ratio of 80% to 90%, with dividends expected to be fully franked.
 

What to do with your Coles shares

Newly demerged companies typically underperform in the short term (first six months post listing), before finding support and outperforming over the medium term. An explanation for this observation is that following the demerger, the market is awash with holders who decide that they don’t really want to own shares in the newly demerged company and look to offload their holdings. Over time, the market recognizes the potential in the company under the refreshed management team and institutions buy the stock.

In the case of Coles, it is a very mature business competing against Woolworths, IGA, Aldi, Costco and Kaufland. Interestingly, Coles suggests that its market share (and that of its main competitor, Woolworths) has remained relatively static over the last six years, despite the heightened competition.
 

Grocery Market Share 2012 – 2018

Source: Coles

What I find interesting from the above chart is that Aldi has already established a share of 10% and that the trend is higher. This is the issue for Coles moving forward – the discount super market chains (Aldi, Costco and in due course Kaufland) are not only forcing the majors to compete on price and crunch margins, they are winning the customer battle.

Coles will be attractive to investors who want a stock with a higher, fully-franked dividend yield. However, the industry dynamics are against Coles and it is not clear what the path for earnings growth is. Coles will also be facing the prospect of additional capex as it builds its new distribution centres. Those looking to exit their new Coles investment might want to act early.