How Coles became a strong link in Wesfarmers' chain

Coles' historic double-digit return on capital is testament to Ian McLeod's focus on investment and retailing basics. His new role will be pivotal in creating long-term value for shareholders.

Whether it was serendipity or not, the proximity of the announcement of Ian McLeod’s shift out of the chief executive role at Coles and the supermarket group’s achievement of a major milestone in its history within the Wesfarmers group creates a neat punctuation point in Coles’ turnaround.

Yesterday, just over five-and-a-half years after McLeod joined Wesfarmers to head-up the effort to rebuild Coles, Wesfarmers announced he would shift across to a group (and rather undefined) role as Wesfarmers’ commercial director. He will be succeeded at Coles by one of his key team members, John Durkan.

The obvious conclusion from that announcement was that Wesfarmers believed that McLeod had essentially achieved the task set for him when he joined the group in 2008 and rebuilt Coles’ foundations to the point where it was safe to hand the business over to the very well-credentialed Durkan.

Today’s interim result contained what the market has increasingly become accustomed to since McLeod and his team began generating momentum in Coles’ performance. Coles lifted its earnings before interest and tax an impressive 10.7 per cent to $836 million in the half.

Of great symbolic importance, however – and the perfect note for McLeod to end his Coles’ role – was the increase in the business’ return on capital from 9.2 per cent to 10 per cent. Coles has finally achieved a double-digit return on capital.

Some of the criticism of Coles’ return on capital in the past has been misguided. The $19 billion or so Wesfarmers paid for the Coles Group brands back in 2007 was funded largely by its own scrip during a pre-crisis period when that scrip was arguably trading at bubble-like levels. The rehabilitation of Coles has also involved heavy investment by Wesfarmers, with a patient eye to the longer term, which also depressed returns.

Nevertheless, there has been pressure on Wesfarmers to lift Coles’ returns as well as its own. The 10 per cent return on capital finally achieved by Coles signals that both the division and the group are heading strongly in the right direction and for the right underlying reasons.

Coles’ resurgence has been strong and steady, driven by vastly improved retailing basics, significant investment, consistent and solid increases in sales and profits and a big dash of creativity. It has kept its major competitor, Woolworths, off-balance until quite recently.

It is a sustainable improvement that is now moving into a slightly different phase, with an accelerated store refurbishment program and some strategic expansion of the store network.

Wesfarmers is also starting to recycle some of Coles’ properties, as it is also doing within its Bunnings hardware business, which will release capital and enhance returns.

Bunnings is another illustration of the longer term and strategic approach Wesfarmers applies to its businesses.

When faced with the entry of Woolworths and its US partner Lowe’s into the big-box format end of the hardware sector, Bunnings sacrificed some of its remarkable return on capital and earnings growth rate to ready itself for the contest and accelerate its own expansion. The early difficulties Woolworths’ Masters chain is having is testimony to Bunnings’ competitive strengths.

Bunnings’ earnings before interest and tax were up 8.5 per cent in the latest half on a 10.4 per cent increase in revenue. Its return on capital rose from 25.5 per cent to 27.6 per cent. Its brief period of defensiveness appears to have passed and, as it recycles properties and capital, there should be further improvements to its returns on capital.

Among Wesfarmers’ other retail brands, Kmart continues to generate big increases in earnings and margins (EBIT rose 5.7 per cent to $260 million) despite flat-lining sales. Its return on capital jumped from 22.8 per cent to 26.8 per cent. Office Supplies, which reports to Bunnings’ John Gillam, lifted its EBIT 10.5 per cent to $42 million and its return on capital to 8.7 per cent.

Target is the troublesome brand, with its EBIT falling from $148 million to $70 million. Wesfarmers parachuted another of McLeod’s protégés, Stuart Machin, into the business. However, he is only in the initial phase of an attempt to stabilise, re-engineer and recreate the brand.

Amid Wesfarmers’ other operations, its resources unit continued to experience falling earnings (EBIT was down 36.6 per cent);  insurance earnings edged down 4.8 per cent; industrial and safety experienced a 17 per cent decline; and the chemicals division edged its contribution up almost 6 per cent.

Overall, however, the performance of the core retail brands drove an 11.2 per cent rise in the group’s earnings and helped lift the group’s return on capital from 8.8 per cent to 9.4 per cent.

With the strength of its retail earnings, the sale and leaseback program for its retail stores accelerating, $1 billion of free cash flow in the half, and the probable proceeds of its $1.85 billion sale of most of its insurance operations to IAG to come, Wesfarmers is soon going to confront some interesting challenges.

Ahead of the insurance sale, it has net debt of about $6 billion in a $44 billion balance sheet. It has a share price that reflects a prospective price-earnings ratio approaching 20 times. In an historical context, it will be under-leveraged at a time when both debt and equity are cheap. It will soon be in a not dissimilar position to the one it was in before it made the audacious bid for Coles.

Goyder and his small corporate team – which will now include McLeod – will have to weigh up the competing merits of conducting capital management programs, paying out big special dividends or looking for another big and transforming acquisition.

Goyder wouldn’t have shifted McLeod from Coles to a vague corporate role that reports directly to him unless he had something meaningful and material to the group’s value to do. McLeod’s success at Coles would have brought him to the attention of every major food retailer in the world, so one assumes he wouldn’t have agreed to the move unless he saw a new and satisfying challenge ahead.

Both McLeod and Durkan have been receiving approaches from both domestic companies and from offshore, which was a major factor in the management shuffle.

McLeod’s move probably isn’t to be Goyder’s heir apparent. Within Wesfarmers, finance director Terry Bowen is seen as the clear favourite to succeed Goyder when he eventually retires.

There appear to be two broad dimensions to McLeod’s new role.

One is to help all Wesfarmers’ domestic businesses where he can, particularly in trying to develop stronger online channels. The other is to look for acquisitions, here and offshore, and take advantage of the group’s balance sheet.

Historically, while Wesfarmers has made routine small acquisitions, it has periodically sought to make transforming acquisitions like Coles where it can create substantial value for shareholders in the long term. Finding the next big thing would be a sensible way to deploy McLeod’s skills, particularly if it were a big move into retailing offshore.

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