Why Wesfarmers is selling Coles

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The floating of Coles as a separate company, with a market cap as high as $20 billion, will free Wesfarmers to hunt out bargains and opportunities for high growth.

Australia’s largest private employer, in its play to spin off Coles, is just re-weighting the allocation of capital in its portfolio to higher-growth businesses.

Coles accounts for about 60% of capital deployed by Wesfarmers, but only about 34% of divisional earnings.

The supermarket chain bought by Wesfarmers in 2007 has been lagging its main competitor, Woolworths, in sales growth. For Woolworths, Australian food sales rose by 4.9% for the latest half year. Coles managed 1.9%.

In the latest half year results, Coles’ EBIT (earnings before interest and tax) fell 14.1% to $790 million. Revenue was weaker at $19.98 billion, down 0.4%.

But there are signs of improvement. Growth accelerated in the second quarter, better than it had for six quarters.

While Wesfarmers says Coles has developed strong investment fundamentals, with a strong balance sheet and dividend paying capacity, it sees opportunity elsewhere.

Wesfarmers wants to apply its capital “toward businesses with strong future earnings growth prospects”.

Michael McCarthy, chief market startegist at CMC, says that quote is a big clue to what Wesfarmers plans.

“As investors examine Wesfarmers’ proposals it’s likely traders will leap to speculation about possible acquisitions,” he says.

“The diverse portfolio of businesses under the Wesfarmers umbrella mean there are few limits to the range of potential targets.”

Citi says acquisitions are likely to be a domestic industrial business.

“This decisive action on Coles indicates the management team and board are able to move quickly, and will likely be decisive around Bunnings UK&I (the UK busienss) as well,” Citi said in a note to clients.

“This is a positive development for Wesfarmers, as shareholders can now gain exposure to a Wesfarmers business primarily driven by Bunnings ANZ.”

Being poured into the new company is a network of 806 supermarkets, plus Liquorland, Vintage Cellars, First Choice Liquor, Coles Express, Coles Financial Services and Spirit Hotels.

Wesfarmers is keeping Bunnings, Kmart, Target, Officeworks and its industrials portfolio. It will also keep a foot in the Coles camp with a holding up to 20%.

The decision follows a review of the Wesfarmers portfolio and an assessment of the composition of its capital employed.

In short, Wesfarmers is looking for higher returns and will seek them via acquisitions.

“A demerger of Coles will facilitate greater focus by Wesfarmers on growth opportunities within its remaining businesses and the pursuit of value accretive transactions,” says managing director Rob Scott.

“The capacity to act opportunistically will be retained through a strong balance sheet and a cash generative portfolio.”

The initial reaction from the market has been positive.

Wesfarmer shares jumped 5.5% to $43.48.

Ord Minnett is maintaining its “hold” recommendation on Wesfarmers with a $40.00 target price.

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