Investment Matters

The biggest writedown in Australian corporate history?

The demerger of Coles and Wesfarmers is getting closer to a conclusion.  A shareholder vote is scheduled for 15-Nov-18 (and assuming shareholder approval, they will trade as separate entities from 22-Nov-18). 

The scheme booklet was released this week.  We decided to review the demerged entities, as per the Scheme Booklet, to form some preliminary thoughts (and, if so indicated, take those thoughts into a more in-depth analysis).

Stated merger rationale

My summary of the demerger rationale presented in the Coles Demerger Presentation and Chairman’s letter in the front of the Scheme Booklet: for Wesfarmers it will provide more growth opportunities, greater flexibility, and increased shareholder returns.  It wants to make investments that offer higher growth prospects than Coles.

For Coles, the demerger rationale is: Coles is “expected to be attractive to shareholders seeking earnings growth with defensive characteristics”. 

As an additional point, the Chairman’s letter at the front of the Scheme Booklet noted that Coles accounted for approximately 62% of the Group’s capital employed and contributed one third of Group divisional earnings.  (More on this statement below.)

What stands out

A $12 billion writedown.  $12 billion of shareholder’s equity has been wiped out – perhaps the biggest writedown in Australia’s corporate history.

The $12 billion writedown was described with weasel-words as the “de-recognition of goodwill and intangibles that arose from Wesfarmers’ acquisition of Coles in 2008” (source: Demerger Scheme Booklet, note 3. to Table 6).

Note: Goodwill is a type of intangible asset that is created when a company acquires a company – it is the difference between the acquisition price and the net assets of the acquired entity.

In essence, Wesfarmers paid way too much when it acquired Coles.  Now it seems that, under accounting rules, Coles can’t have its own goodwill on its balance sheet.  Therefore it needs to be written off.  But at the end of the day, that is $12 billion of shareholder value that was wasted.

Yes, future returns for Wesfarmers’ shareholders should be increased – Return on Capital, for instance, will be considerably higher when $12 billion of that capital doesn’t exist anymore.  Wesfarmers created the goodwill / capital by paying too much for Coles.  Now it is writing it off.  Shareholders suffer.

And to the point the Chairman made about Coles representing 62% of Wesfarmers’ capital yet a third of earnings.  It is the same point – this is self-inflicted; it was a consequence of Wesfarmers paying too much for Coles.  And shareholders pay the price – but it is just not easily visible, and it is without accountability.

But let’s put the destruction of shareholder value aside – looking to the future, does the demerger stack up?  We will briefly consider the investment opportunity of the two separate entities (assuming shareholders vote in favour).

Gearing

To provide some context for future sections, the table below provides the key gearing and debt metrics before and after demerger (assuming shareholder approval).

* Gearing ex-intangibles is a measure of gearing in relation to tangible assets.

Source: Wesfarmers FY-18 Annual Report, Wesfarmers Demerger Scheme Booklet, First Samuel

Coles

Coles operates in a highly competitive environment.  There has been a well-timed, short-term boost in regards to trading performance - from the successful plastic bag transition (compared to Woolworths) and a gimmicky promotion.  But Woolworths is a strong company which competes in earnest, and other players (namely Aldi and Costco) are adding competitive pressure.

Technically, gearing is reasonable at 35.0%.  But there are two factors that, we believe, mean it is in reality quite high.  1. High intangible asset base: 57.5% of Coles’ assets are intangible, and yes that’s after the $12 billion writedown.  This means debt as a proportion of tangible assets is also high.  2. Coles has $9.7 billion of lease liabilities (source: Demerger Scheme Booklet, para 2.13.13).  From FY-19, net present value of lease liabilities will need to be recognised on Coles’ balance sheet – materially increasing the effective gearing of the company.

Coles operates on tight margins compared to many other industrial or retailing companies.  And these margins are in decline: EBIT margin was 4.5% in FY-16 and 3.6% FY-18 (source: Demerger Scheme Booklet, para 2.13.4).

Combining the competitive environment, gearing, and thin margins, means that Coles is a company that, we believe, isn’t structurally attractive and is actually quite a high risk investment (which is contrary to the perception of many).  It would need to trade on a very compelling share price post demerger for us to look further.  Therefore, we move to consideration of Wesfarmers.

Wesfarmers

Post demerger, Wesfarmers will comprise Bunnings (47.2% of FY-18 earnings [EBIT]), Kmart and Target (20.7%), Officeworks (27.2%), and its industrial businesses (4.9%) (source: Demerger Scheme Booklet, para 3.3).

As mentioned above, Wesfarmers intends to be a growth company.  Earnings growth is somewhat achievable from its existing portfolio of businesses, but the quantum is fairly limited.  The real opportunity, and how it has engineered the demerger via low debt and low gearing (including gearing ex-intangibles), is to grow by acquisition.

Wesfarmers has a mixed history when it comes to building shareholder value via acquisition.  There have been successes, recent ones including:

  1. the sale of Kmart Tyre and Auto Service (KTAS) for $350m.  It was acquired as part of the Coles acquisition in 2007.  Its effective acquisition price and earnings have not been specifically disclosed.  The sale price was generally viewed as full.  Wesfarmers probably realised a good return – but a specific IRR or other metric was not disclosed. 
  2. the sale of its 40% stake in the Bengalla coal mine for $860m. Again, a specific IRR or other metric was not disclosed, but it probably made a reasonable return. And,
  3. the sale of its Curragh coal mine for $700m.  Wesfarmers advised this investment had generated a 49% p.a. IRR over the 17 years it owned it (it is assumed that includes an allowance for the $565m writedown on this asset in FY-16).  It also has a profit-sharing mechanism for Curragh in CY-18 and CY-19.

Note: the announcement of a profit (or loss) figure in divestment announcements does not represent the profit (or loss) the investment made over the time of ownership – it is the difference to the book value (i.e. balance sheet holding value) on the date the asset was sold (which may have changed over the ownership period), and also excludes operating profits (or losses) generated by the investment.

There have also been failures.  The two notable ones are Coles – as mentioned above - and the failed attempted expansion of Bunnings into the UK.  The acquisition of the UK-based company Homebase formed the foundation of the Bunnings UK expansion.  After the Bunnings expansion failed, Wesfarmers sold Homebase in Jun-18, for a loss of $375m.  It took an additional $1.02 billion of impairments associated with the Bunnings UK venture in FY-18 (source: Wesfarmers FY-18 Annual Report). 

Since the mid-2000’s, the problem for Wesfarmers’ shareholders is that it appears, on available information, the value destruction from Bunnings UK and Coles outweighs the value creation from other acquisitions.

And so one of the key questions for us as potential Wesfarmers investors is do we have faith that future acquisitions will be value accretive for shareholders?

Conclusion

The Coles demerger has come about because of the constraints Wesfarmers’ current balance sheet presents to future growth – especially the high intangible asset base.  And the main cause of this was the too-high price paid by Wesfarmers for Coles in FY-08.  The demerger proposal solves this by wiping out $12 billion of shareholder equity.

But putting the past aside, we will watch how the demerged companies trade (assuming shareholder approval of the demerger) from 22-Nov-18.  At this stage, we would have to see compelling share prices before considering them as realistic investment opportunities for you.  Additionally, for Wesfarmers ex-Coles, we need to be more comfortable with their acquisition strategy and discipline than we currently are.

- Fleur Graves