Wesfarmers to demerge Coles

The decision follows a review of WES's portfolio and management's intention to target a higher capital weighting towards businesses with strong future growth prospects. For financial year 2018/2019, we estimate Coles represents 34 per cent of the Wesfarmers group’s earnings (EBIT) while Home Improvement represents 33pc.  After the demerger of Coles, Home Improvement's percentage of earnings will rise substantially to 50pc of group earnings (EBIT). This composition will likely change further over time as management pursues acquisitions and divestments.

After the demerger, WES intends to retain a minority stake of 20pc in Coles to support strategic alignment between WES and Coles in relation to various growth initiatives such as digital and data. The demerger is subject to final board approval, third party consents, and regulatory and shareholder approvals. If approved, the transaction is expected to be completed in financial year 2018/2019.   In addition to the demerger, WES also announced that current Coles managing director John Durkan will step down and be replaced by Steven Cain.

Given Rob Scott's focus on return on capital we believe the demerger makes sense. Coles generates only 9pc return on capital (ROC) but consumes about 60pc of WES's capital employed. This is well below Bunnings (31pc), Department Stores (26pc), Industrials (18pc) and Officeworks (16pc).

By demerging Coles management can focus on deploying capital to better returning businesses within the portfolio and free up capacity to make value accretive acquisitions. We think this move makes sense and given our bearish view on the long term outlook for the supermarket sector, a WES without Coles looks to be a stronger business that should trade on a higher multiple.  As a standalone entity we value Coles on an enterprise value of A$17.7bn based on a 12x FY19F EV/EBIT multiple, in line with global supermarket peers.

We think the demerger makes sense given long term structural headwinds in the supermarket sector and it frees up capacity to invest in higher returning businesses and/or pursue M&A opportunities. While no material changes to our forecasts for earnings have been made, we value WES at $44.65. We believe a greater focus on the existing stronger returning businesses should lead to improved growth prospects and a higher trading multiple.