Recently, Wesfarmers Limited (ASX: WES) announced its intention to demerge the Coles business into a separate ASX-listed company. While WES will retain up to a 20 per cent stake in Coles, the demerger effectively splits the company into two separate entities, with WES owning Bunnings, Kmart, Target, and Officeworks, as well as WES’ Industrials and “Other” divisions.
The market has responded positively to the announcement, with WES shares trading around 5 per cent above the pre-announcement level, so shareholders appear better off, but does the move create genuine value for shareholders?
The answer probably is yes and no, depending on exactly how you define value.
In terms of intrinsic value, which is calculated by reference to the underlying cash flows and their risks, it is hard to see the demerger creating genuine value. Rather, it results in significant transaction costs being incurred without obvious improvement to the revenue or profitability of the underlying businesses, and so from an intrinsic value perspective the demerger is arguably neutral to negative. This is the value measure that drives our assessment of investment merit, and so from an MIM perspective, our estimate of overall value has not improved.
However, value and price are different things, and to the extent that the transaction increases the price of Wesfarmers shares, it is reasonable to conclude that shareholders are better off.
This improvement stems from the way the equity market ascribes value to a dollar of cashflows, and the fact that different shareholders can have different preferences.
Compared with the remaining WES businesses, Coles has relatively modest growth prospects, but relatively resilient earnings. It has greatest appeal to investors that want a steady income stream.
The remaining businesses have relatively stronger growth prospects, and greater potential for the corporate head office to add shareholder value through deploying capital wisely in organic growth or new acquisitions. To the extent that the company can do this effectively, the new, smaller WES can deliver a better growth profile than it could if it still owned Coles. Accordingly, the “new” WES has stronger appeal for investors attracted to this type of financial profile.
The demerger then, provides greater scope for individual investors to satisfy their own particular investment objectives, and that flexibility is worth something to the equity market.
Having significantly improved the performance of the Coles business in the past decade, it is also fair to note that WES probably has little more to add to Coles in terms of management discipline, and it makes sense for it to focus its attention elsewhere. The acquisition of Coles may not have been well-timed, but in terms of management execution WES acquitted itself well, and has probably earned the right to consider other significant acquisition opportunities.
To summarise, WES is an unusual beast, in that it has managed to add considerable value over a long period of time using a conglomerate model that most others have failed to make work.
As it positions itself to continue along this path, it is good to see WES doing what WES is good at.
The Montgomery Funds own shares in Wesfarmers
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Tim is the Portfolio Manager of The Montgomery Fund – a concentrated, All-cap Australian equity fund that aims to generate capital growth and income. Montgomery focuses on owning high quality businesses and generating superior returns.