Wesfarmers dawdles on Coles

If Coles had been acquired by a private equity group rather than the publicly listed Wesfarmers the whole exercise would have been modelled on Myer, where a private equity-backed consortium led by Bernie Brooks has bought the company. It a very different process from the step-by-step way Wesfarmers chief executive Richard Goyder has approached the deal.

Wesfarmers has bought a fabulous long-term prize but in my view it’s a pity Goyder did not model his acquisition strategies on Myer.

In the case of Myer (and Coles under private equity) all the money was arranged on a long-term basis. In fairness to Wesfarmers, this long-term money was not available, which is why the private equity consortiums pulled back.

Wesfarmers proceeded with $4 billion in short-term money, due to be renewed next October. At the moment the cost of renewing that money is rising as part of world uncertainty.

Second, in the case of Myer, the new managers were all arranged in advance and on acquisition walked in and began transforming the company from day one. In the first 100 days Myer was brilliantly turned upside down and no one had any doubt about what they had to do. It would have also worked brilliantly in Coles.

Goyder waited until the deal was close to done before going on a full search for a new chief executive for Coles. It is a key appointment but at the time of writing, the chief executive still has not been announced. An enormous opportunity for initial momentum has been lost. It’s true that a lot of work has been done and the man who rejuvenated supermarket giant ASDA, the UK-based Archie Norman, has been working with Wesfarmers. He says Coles is a wonderful opportunity: “We have to break it apart and put it back together again. We are not going to tinker on the edges”, Norman suggested.

My experience with most takeovers that require a drastic reorganisation is that the first 100 days are vital. After that it's harder and more risky because the rulers get embedded in basic decisions. Wesfarmers took control on November 23, so 63 days have already gone – 37 to go. Woolworths’ chief executive Michael Luscombe is winning market share from Coles every week and must be bedside himself with joy as each day goes by without big action from his main opponent.

Meanwhile, the hard numbers tell a fascinating strategic story. Last year, Wesfarmers earned $2.10 a share, which was down on the $2.36 on what the company earned in 2005-06, mainly because of lower coal prices.

The company has not announced an expected Coles profit but revealed that pro forma 2007 Coles cash flow levels translate to just $85 million for Wesfarmers (after Wesfarmers’ interest and capital expenditure).

Wesfarmers issued about $11 billion worth of equity at current prices ($13 billion before the market fall) to gain a token amount of cash flow.

So to make this deal work, Wesfarmers must tap the huge cost reductions and extra revenue opportunities that lie dormant in Coles.

Bunnings is doing well and coal will enjoy better returns in the current half-year, but some analysts are still tipping that Wesfarmers’ profit in the current year will fall below $1.70 a share – a 28% fall in two years. On a share price of $37.30, the stock has an expected price/earnings multiple of about 22, which is high, particularly as there is not much expected joy in 2008-09 when some analysts believe Wesfarmers can only lift earnings per share to about $2.

Even in 2009-10, expectations from many brokers are still only around $2.20 a share – below 2005-06, the year after former Wesfarmers chief executive Michael Chaney stepped down. If the long-awaited Wesfarmers bonanza arrives in 2010-11, which will be three years after the Coles acquisition, then I guess everyone will be happy.

But given the abundance of low-hanging fruit, it could have been delivered a lot faster and I must say to have lost 63 days increases the risk.

And on the of subject of risk, Wesfarmers paid a dividend of $2.25 a share in 2006-07 but 25¢ of that came from the sale of Australian Railroad. So the base dividend was $2 a share. If the analysts’ forecasts of profit are right, then a $2 dividend in 2007-08 will not be covered by trading profits and in 2008-09 it will be touch and go. If anything goes wrong, that $2 dividend rate is vulnerable.

Wesfarmers has about $12 billion in debt but the market value of shareholders’ funds is about $26 billion, so the company is not excessively leveraged although Coles itself is leveraged to the hilt.

When you look closer at the Wesfarmers business you realise that the time it will take to deliver on Coles means that Wesfarmers may hang on to coal a longer than is prudent, given the looming threat of big levies on carbon.

Yet the Wesfarmers asset structure has the potential to be transformed. Using the 2007 Coles and Wesfarmers figures, the group’s base earnings before interest tax depreciation and amortisation (EBITDA) was doubled by the Coles acquisition to $3.4 billion.

At the moment Wesfarmers divides its retail chains and energy businesses each into a couple of baskets. If we adopt more conventional grouping, we see that based on last year’s figures Wesfarmers retail (Coles and Bunnings) had an EBITDA of $2.3 billion and energy (coal and gas) generated an EBITDA of just over $600 million. That leaves $500 million for four businesses including “other” – an average of about $125 million per business. Yet these businesses get the most enormous amount of management attention.

There would be great market joy if investors had the chance to invest in the largest retailer in the country and the energy assets were sold for the big prices they currently would command. The “small” businesses would attract buyers because they are strategic to their industries.

But Wesfarmers has no intention of splitting the empire because it is dedicated to its management style and believes passionately that this is the way to create long-term growth. The market has been sold on the Wesfarmers process and is prepared to accept an expected 2009-10 earnings per share will be either less or about the same as 2005-06. It represents a remarkable marketing job by Wesfarmers and shows that institutions can be persuaded to think long term.

But I don’t think there is room for mistakes. If the failure to act in the first 100 days at Coles puts the whole project back and/or one of the divisions goes seriously wrong, then watch out for the market backlash.

And what of Wesfarmers’ coal division? Unless the plans are well advanced I can’t see any new coal-fired power station being built in Australia. China is beginning to embrace anti-carbon policies so in a couple of years new coal-fired stations will be rare.

And once we start taxing carbon at $100–150 a tonne (and perhaps more), then the whole idea of coal being a cheap power source goes out the window. This is the time for Wesfarmers to sell coal. Wesfarmers is bullish on coal but even if some directors have doubts, Wesfarmers expects a big rise in coal profits in the next couple of years which will give them time to get Coles right.

Wesfarmers shareholders have the Coles bonanza to enjoy in three or four years and the likelihood that if anything goes wrong the company will split its huge asset base. But in fact Wesfarmers has been transformed from a genuine conglomerate to Australia’s largest retailer, which also owns a big energy business with various bits and pieced added on the end.