Wesfarmers sets Coles free

Richard Goyder's tenure at Wesfarmers was defined by the takeover of Coles Group in 2007. By 2013 it was clear that the turnaround of Coles' food and liquor business had been successful.

Wesfarmers' share price has gone sideways ever since. Five years ago this week the stock closed at $43, and today it trades at about – wait for it – $43.

Earnings per share growth is a better (although not perfect) way to measure long-term performance. Over the same five-year period earnings per share have grown at 5.3% a year – respectable although hardly exciting.

So last week's announcement by Rob Scott – Goyder's successor – that Wesfarmers would demerge Coles was telling. The announcement was pretty clear: Scott wants to reallocate capital towards businesses with ‘strong future earnings growth prospects'. Scott wants to turn Wesfarmers from a ‘plodder' into a ‘grower' again.

This suggests the turnaround of the Coles food, liquor and fuel business (‘Coles') is largely complete from Wesfarmers' perspective. Coles' operating profit grew from $779m in 2009 to $1,609m in 2017 (although earnings will fall this year).

A costly turnaround

The turnaround has been a capital-intensive exercise. Over $8bn of new capital has been invested in Coles since 2009, or around $1bn a year. We'd expect a slightly lower annual spend once Coles is separately listed and, as some of the capital expenditure is directed towards saleable property, on an underlying basis the business is less capital intensive than it looks.

Coles' earnings should still grow over time, although at a lower annual rate than the 9.5% produced under Wesfarmers' ownership. Coles will be a large company in its own right – one of the 30 largest on the ASX.

It will probably take six months before Wesfarmers shareholders get to vote on the demerger and Coles is separately listed. But we'll look forward to covering Coles as a separately listed company and will say more as further information is released.

So what does this mean for Wesfarmers itself? Well, we approve of Scott taking a more active approach to the business portfolio. As we've said before, this will almost certainly involve some major acquisitions (and divestments) over time.

Down down, gearing is down

Wesfarmers is likely to transfer some debt into the Coles' listed structure, so its own gearing should fall. That should enable Scott to make a large acquisition if one presents itself, which it almost certainly will.

Wesfarmers will also retain a 20% stake in Coles following the demerger, which could be sold if necessary. It's also possible that Coles could be the listed vehicle into which Wesfarmers sells its other retail assets – such as Officeworks – as its own business portfolio evolves.

But it's not all about corporate manoeuvrings. Scott's focus on the so-far slightly fuzzy area of ‘data and digital initiatives' could be a source of additional value to both Wesfarmers and Coles.

The two companies will jointly own the Flybuys loyalty program, which could eventually rival Qantas's valuable frequent flyer scheme. Flybuys' earnings aren't currently material but the business could be worth $1bn or more eventually (colleague Graham Witcomb has estimated Qantas's frequent flyer scheme is worth at least $3bn).

All this adds up to a slightly more positive outlook for Wesfarmers, although the stock isn't quite cheap enough to buy at this point. However, we'll be reviewing our valuation in more detail over the next month or so and, given management's more activist approach, there's potentially some upside that's not being priced in. For now Wesfarmers is a HOLD.