A good platform

The immediate reaction of the sharemarket to Wesfarmers' first half results appeared to be one of relief. In the current volatile market environment, no bad news is great news.

The result is Wesfarmers' first since it took ownership of Coles Group in late November. Given the pressure and distractions generated by the long-running, highly-visible and highly-destabilising year-long auctioning of the big retailer, there was a concern that its performance would deteriorate, particularly as the hand-over to Wesfarmers occurred in the lead-up to the critical Christmas/New Year trading season. Also, it had been under a fierce and escalating assault from Woolworths, which tried to exploit Coles' sustained period of vulnerability.

While one can't draw any long-term conclusions from just over a month's trading (Wesfarmers took possession of Coles on November 23) the good news for Wesfarmers shareholders, including the mass of Coles shareholders who took Wesfarmers' scrip, is that none of the things that could have gone wrong did go wrong. The Coles' portfolio traded well.

The much-maligned John Fletcher and his team handed over businesses that produced both solid sales and earnings growth. The key supermarket business lifted sales 7 per cent and generated earnings before interest and tax of $130 million.

While, as Wesfarmers was at pains to point out, there is a long way to go to re-position the division so that it produces returns competitive with Woolworths, that was a very solid performance. It is particularly noteworthy that the bungled Bi-Lo conversions that effectively ended any chance of Coles' remaining independent no longer appear to be an issue – Wesfarmers said both the converted and unconverted Bi-Lo stores showed positive signs.

Even Kmart, a perennial disappointment, showed improvement. Wesfarmers is too astute no to have taken the most conservative approach it could to Coles' numbers.

With Christmas behind it, Wesfarmers is stepping up the urgency of its attempt to renovate the Coles' group, which has adopted the decentralised Wesfarmers' model and been broken down into its individual brands. Group-wide supply chain and cost reduction programs (which delivered $288 million of cost-reductions before Wesfarmers took control) have been shut down, although Wesfarmers is now embarking on its own restructuring strategies.

Coles new supermarket supremo, Ian McLeod, doesn't arrive from the UK until May, but the attempts to improve the supermarket offering, including attacking Coles' chronic issues with on-shelf availability and its fresh food offering relative to Woolworths, are intensifying.

Wesfarmers can't afford to wait for McLeod because of the leverage Coles brought with it, both financial and operational. Coles has more than doubled Wesfarmers' revenue base and nearly trebled its cash flows. The acquisition has also swamped its return on funds, left it with a net debt-to-equity ratio of more than 70 per cent and confronted it with the daunting task of re-financing large amounts of short-term debt this year.

It is the operational leverage that attracted Wesfarmers to Coles – there was no other potential play in this country that offered the prospect of so much value creation for Wesfarmers if it executed the rehabilitation of Coles well. The financial leverage magnifies the potential rewards – as well as the risks. Trying to re-make Coles will be a long, expensive and high-risk process.

Wesfarmers has to refinance $4 billion of the debt it took on for the deal. Wesfarmers is highly-rated and high-performing and, with Coles, generating loads of cash – $1.2 billion in the half. That debt is, however, going to cost it a lot more than it envisaged when it started stalking Coles, long before the sub-prime crisis emerged. It also needs to fund a massive capital investment program in Coles over the next few years.

Wesfarmers plans an underwriting of its dividend reinvestment plan, which would locked in between about $340 million and $450 million of new equity from the interim dividend. If it extended the underwriting to its final dividend, Wesfarmers could raise as much as $1.4 billion from the program. It is also looking at hybrid capital and convertible securities.

If it had to, the conglomerate nature of Wesfarmers – and the fact that its various divisions are high-performing – means it has the option of selling one or more of its non-retailing businesses if it comes under any pressure. Wesfarmers is dispassionate about its portfolio.

As it imposes the ''Wesfarmers' model'' on Coles and starts another bout of restructuring within an organisation that, after more than five years of change and last year's protracted uncertainty must be weary of change, Wesfarmers is entering the period of greatest operational and financial risk. It knows that Woolworths will take every opportunity to pressure and destabilise it.

But at least it starts that process with businesses that are in better shape than might have been expected. From this point on, the destiny of the former Coles' brands, and indeed Wesfarmers itself, will be determined by the effectiveness of Wesfarmers' management, their strategies and their execution.