Woolworths to benefit from more rational market after Coles demerger

Sue Mitchell
Oct 8 2018
AFR

Woolworths is tipped to emerge as a major beneficiary of Wesfarmers’ demerger of Coles as a decade of aggressive price cutting comes to an end.

Fund managers say the $20 billion demerger is likely to lead to the most benign industry conditions in almost a decade because a stand-alone Coles will have less capacity to invest heavily in price while spending $1 billion automating its supply chain and distributing 80 per cent to 90 per cent of earnings in dividends.

“The guys who will be happiest about the demerger will be [Coles’] biggest competitor,” said Wavestone Capital fund manager Raaz Bhuyan.

“Coles stand-alone is likely to make for a more rational industry, therefore it’s probably good for all players, at least before Kaufland or Amazon comes in,” Mr Bhuyan told The Australian Financial Review on Monday.

“All the forecasts [for capex, dividend payout ratios and borrowings] are based around a pretty rational market,” he said.

The risk was that Woolworths, after sinking $1 billion into prices and service to regain market share between 2016 and 2017, started ramping up discounting at a time when Coles could least afford to strike back, Mr Bhuyan said.

“If I was a shareholder of Coles I wouldn’t take comfort from the 80 to 90 per cent payout ratio … it’s going to depend on the industry at that point,” he said.

As Wesfarmers and Coles executives prepare to embark on a three-week national and international roadshow to sell the merits of the demerger, investors and analysts are still poring through the 230-page scheme of arrangement documents lodged late on Friday afternoon.

Many are divided

Most investors and analysts agree with the rationale for the demerger, which will enable Wesfarmers to shift capital towards businesses with higher earnings growth prospects, but many are divided over Coles’ prospects as a stand-alone listed entity.

Of the 10 major investment banks and brokers who cover Wesfarmers, nine have sell, underweight or neutral recommendations and one, Macquarie Equities, is advising on the demerger and is restricted.

Citigroup analyst Bryan Raymond summed up the market’s concerns in a report late on Friday.

 “Coles’ flexibility to reinvest in price, service and the store network will likely be limited given lower than expected cash conversion and a significant supply chain investment over the next five years,” said Mr Raymond, who prefers Woolworths to Wesfarmers.

Wesfarmers’ third largest shareholder, Legg Mason, believes the demerger will enable Wesfarmers to focus on higher-returning, faster-growing businesses such as Bunnings, while setting up Coles for a sustainable future.

“We get a share of Coles and a share of Wesfarmers,” said Legg Mason retail analyst Jim Power. “We’re not going to own something we didn’t previously own so from that point of view I don’t see it as being a huge problem.”

 Mr Power is confident in Coles’ ability to pay out 80 to 90 per cent of dividends, despite higher capex, and believes the strategy of new managing director Steven Cain is superior to that of former managing director John Durkan.

 Mr Cain’s six key “pillars” include improving Coles’ fresh foods and own-brand offers, continuing to shift away from discounting towards everyday low prices, moving from a primarily bricks-and-mortar business to online and click and collect, and tailoring stores rather than having a one-size-fits-all approach. 

On the face of it Mr Cain’s and Mr Durkan’s strategies are similar. However, Mr Power believes under Mr Cain Coles will focus less on cutting costs and products and more on tailoring stores to suit local demographics.

“It’s a big change – Steve’s strategy is very similar to Woolworths’ and it’s a good strategy,” he said.

“John [Durkan] was more about cutting and SKUs. That worked well when Woolworths wasn’t competing but then Woolworths started competing and doing a whole bunch of other things,” he said.

Private-label brands

Mr Power also supports Coles’ plan to boost private-label brands to combat Aldi and establishing small format and convenience stores.

“The industry has already become less competitive and it will continue to become less competitive after Coles gets demerged,” he said. “A rational market is in everyone’s best interests.”

Investors and analysts have also raised concerns about Coles’ plan to take provisions of $130 million to $150 million in 2019 to cover the cost of closing five of its 20 warehouses over the next five years.

Mr Bhuyan said taking big provisions in one year for redundancies when Coles had yet to select sites for the new distribution centres was “cheeky” and could be used to help Coles smooth earnings over the next few years.

However, Mr Power said Wesfarmers’ decision to flag provisions upfront meant investors could monitor the progress.

 

“We know it’s there and we can ask them about it and how quickly the provision is being released,” he said.

 

The five warehouses to close are at Eastern Creek, Smeaton Grange and Goulburn in NSW, and Forest Lake and Heathwood in Queensland.