Coles Group: back up the truck?

What goes around comes around, apparently. And Coles Group came around again yesterday, re-listing on the ASX almost 11 years to the day after the Wesfarmers takeover. Unlike 2007, this version of Coles Group doesn't come with ownership of department store chains Kmart and Target, though, which have remained with Wesfarmers.

If you're a Wesfarmers shareholder, you might have been surprised by the 28% decline in the share price yesterday. Don't be. It simply reflects the demerger of Coles, which means the total value is now split between two separately listed companies. For every one share in Wesfarmers, you now own one share in Coles Group.

Adjusting for Wesfarmers' remaining 15% stake in Coles, the combined market value of the two companies was very similar to the pre-demerger $50.1bn market value of Wesfarmers at Tuesday's close. That makes sense, and was a decent result given market weakness yesterday.

So is Coles or Wesfarmers a Buy? With Wesfarmers recently trading back towards our pre-demerger Buy price of $42, you'd expect we might be getting close for one - or maybe both.

As we hoped, Coles Group did list below our assessment of value. Today we add another stock to our burgeoning Buy list.

Better buy

To recap, Coles Group consists of the Coles' supermarket, Liquorland and First Choice liquor and Coles Express fuel and convenience businesses. It is the slightly weaker supermarket group compared to Woolworths but they're both very high quality businesses. In the very long term our preference would be for Woolworths, but the significantly different sharemarket pricing means Coles is the better buy at present.

Coles is at a much earlier stage of its profit recovery than Woolworths. While Woolworths' 2019 earnings will be up more than 20% from their 2017 nadir, Coles is still bouncing along the bottom. On a pro forma basis, we're expecting Coles Group's operating profit to rise by only 2% this financial year.

At the current price of $12.87, Coles is trading on a 2019 prospective PER of 18. With Coles set to produce excellent free cash flow - despite a ramp-up in capital expenditure - it's also trading on a free cash flow yield of 5%. These are very reasonable metrics for a business of Coles' quality and profit turnaround potential.

While the market is under-estimating the potential for earnings recovery, Coles won't be a high-return stock. If your hurdle is for double digit returns over the long term, then you might give Coles a miss. However, don't dismiss the possibility of decent returns for the first few years as new management drives earnings growth.

Latent upside

In fact, we believe this is a possible reason why Wesfarmers retained a 15% stake in Coles Group. Management didn't want to own Coles forever, but it also understands the market was likely to underprice the stock until earnings growth resumed. A 15% stake allows it to retain some of the latent upside - as well as exert a measure of control while the jointly owned Flybuys business is built.

Coles Group will trade on a deferred settlement basis until 29 November while the share registry gets its act together. Wesfarmers shareholders may not be able to view their Coles shares in their broking account until that date. Anyone who buys Coles on market shouldn't need to settle until then either (although check with your broker if this matters to you).

We're pleased to commence coverage of Coles Group with a positive recommendation. It will be a relatively low risk stock, so our risk ratings start at Low-Medium, with a maximum portfolio weighting of 7%. We think Coles Group is a good enough opportunity to take a decent swing immediately. BUY.  

What about Wesfarmers?

So does the new, slimmed-down Wesfarmers earn an upgrade as well? The company now consists of all its previous businesses, but only 15% of Coles rather than 100%. Bunnings is now Wesfarmers' largest division by far, accounting for more than half of earnings - or three-quarters if you add Kmart too. These two retailers are very important to the valuation.

We're expecting the 'new' Wesfarmers to produce earnings per share of about $1.70 in 2019. Based on the current share price of $31.96, that places the stock on a prospective PER of 19.

However there's reason to think the economic outlook has deteriorated a little. House price weakness has accelerated in Sydney and Melbourne, while there's also evidence of credit tightening following the Royal Commission into the financial services industry.

With that in mind, discretionary retailers such as Bunnings and Kmart might be in for a tougher time. Both are very strong retailers however, and we expect some resilience whatever the economic conditions.

At this stage we're prepared to pay $30.00 a share for the new Wesfarmers, which equates to a PER of 18 (we may tweak this after further analysis). The Buy price reflects both the risks of economic weakness, offset by our favourable view of the new management team's ability to allocate capital. While that probably implies a significant acquisition at some point, we're comfortable with that prospect.

With Wesfarmers becoming smaller - and losing the defensiveness of the Coles business - we're adjusting our risk ratings upwards. Both move from Low to Low-Medium, while we're also reducing our portfolio weighting from 10% from 8%.

While Wesfarmers remains a high quality business with superior growth potential to Coles, the current price isn't quite cheap enough. We're hopeful of another opportunity but the recommendation is HOLD.

Disclosure: The author owns shares in Wesfarmers and Coles Group.