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Wesfarmers’ thinking on spinning-off Coles unconvincing

I’m a fan of corporate demergers or so-called “spin-offs”. In many respects, spin-offs are a better bet than sharemarket floats because more is known about the asset. But I’m struggling with the logic behind Wesfarmers’ intention to demerge Coles and list it on ASX.

History shows the best spin-offs usually involve unrelated assets with low synergies. Foster’s Group’s successful demerger of Treasury Wine Estates (TWE) in 2011 is an example: wine is a different business to beer and TWE had better prospects as a standalone company.

The same is true of Fairfax Media’s demerger of Domain Holdings Australia; BHP Billiton’s separation of the South32 assets; and National Australia Bank’s spin-off of CYBG Plc.

In each case, there was clear logic for asset separation. Fairfax’s traditional media assets and online property platforms were different businesses needing different organisation cultures. South32’s assets struggled to compete for capital with BHP’s tier-one mines. NAB’s UK operations suffered from being part of an Australian bank and needed its own life.

The best demergers benefit the parent and child (spin-off) companies. They allow the parent to focus on its core operations and not be weighed down by operational issues in the spin-off.  The spin-off is energised by new capital or management or as a standalone ASX company.

Australia has had some cracking demergers over the past 10 years: Sydney Airport, Dulux Group, The Star Entertainment Group, Orora, Recall Group, and New Zealand telco Chorus, for example. Further back, Asciano Group, Macquarie Atlas Roads Group, Mayne Pharma Group and fund manager Henderson Group Plc produced good returns among demergers.

I’m not sure Coles will join them. The demerger makes sense for Wesfarmers because it gives investors greater relative exposure to star performer Bunnings. That is why Wesfarmers shares spiked 6% on the demerger news this month. But it’s hard to see how Coles will be a stronger business, and more formidable rival to Woolworths, as a standalone business.

Chart 1: Wesfarmers

Source: ASX            

For starters, the Coles spin-off is not an unrelated asset with low synergies, within Wesfarmers. It’s a retail business that exists within a portfolio of other retail businesses.

One might argue, as Wesfarmers has, that Coles provides a different type of defensive retail exposure compared to Bunnings. Or that Wesfarmers is separating the higher-growth Kmart operation and lower-growth Coles supermarkets – and giving investors a clearer choice. The argument has some logic but is not sufficiently persuasive to support a demerger.

Synergies are another issue. In this world of big data and customer analytics, Coles’ database of millions of customers and their spending habits is extremely valuable. There must be considerable lost synergies by splitting up Wesfarmers’ core retail assets now, and in coming years, as data analytics becomes a bigger part of retail strategies.

I understand what Wesfarmers gets from the demerger. But it’s not as though Coles and its related liquor operations need to be a standalone business to compete for capital or secure sufficient management attention within Wesfarmers. Or attract new management or better incentivise existing management with the lure of being a standalone ASX-listed company.

Coles looks like a business being demerged at a time of growing competition from

Woolworths and foreign retailers that will further shrink operating margins.

I could be wrong, but such spin-offs tend to be weaker companies when freed from their parent, not stronger.

Other retail demergers

Of course, it’s too early to be prescriptive about Coles until Wesfarmers provides more detail on the demerger, expected in FY19. Woolworths could be a winner if Coles underperforms after listing – which often happens in demergers – but it’s hard to get excited about either retailer.

Although it has good quarterly sales momentum, Woolworths, too, faces greater competition from foreign rivals, margin pressure and rising costs. Woolworths looks a touch overvalued at the current price based on consensus analyst forecasts.

Chart 2: Woolworths Group

Source: ASX

Woolworths spin-off Shopping Centres Australasia Property Group (SCP) is among the better-quality small-cap Australian Real Estate Investment Trusts (AREITs) and demergers – and an interesting play on the beleaguered retail sector.

The Woolworths property demerger came to market via a $472-million Initial Public Offering (IPO) in November 2012. Its $1.40 issued shares have performed solidly, now trading at $2.33.

SCP has its critics. Macquarie, for example, has an underperform recommendation, noting SCP’s “lower underlying growth and limited cap-rate concession (lower asset returns)”. Most broking firms have hold recommendations and an average unit-price target of $2.21, based on the consensus of seven analysts, suggests SCP is fully valued at the current price.

I have been positive on SCP for the Switzer Report for several years, first nominating it in January 2014 [1] as one of the better niche AREITs for income investors, when it traded at $1.85. SCP owns 74 neighbourhood and sub-regional shopping centres around Australia.

SCP has an annualised total return (including distributions) of 13.1% over five years, Morningstar data shows. SCP in February reported first-half FY18 net profit of $69.6 million, in line with market expectation. SCP slightly upgraded FY18 earnings and distribution guidance.

I remain optimistic on SCP’s long-term prospect for five reasons. First, anchor tenant Woolworths, which has 34% of SCP space, is showing improving supermarket sales. SCP said Woolworths and Coles are trading well in its centres, and discretionary retailers are improving.

Second, SCP is well placed to make acquisitions. Its balance sheet is strong with gearing of 32.5% at the low end of its target range. A headwind is shopping-centre acquisitions becoming more expensive, something SCP has acknowledged to the market.

Third, SCP is a bigger winner from population growth. Neighbourhood and suburban shopping centres, which often have an anchor supermarket and a dozen or so retailers, are an obvious beneficiary from Australia’s expected population growth.

Fourth, I like the neighbourhood/suburban shopping theme for retail AREITs. As I have written before, the best retail AREITs will be the “fortress malls” that are destination shopping experiences, such as Westfield Corporation, and smaller neighbourhood-style centres. Shopping malls caught in the middle, those too small to appeal to destination shoppers and full of discretionary retailers that will be smashed by online competition, are best avoided.

Finally, SCP suits conservative income-seeking investors. The trust has strong core tenants in Woolworths and Wesfarmers (53% of gross rent) and about 72% of its rent by category is fresh food/liquor, services and pharmacy/medical. The troubled apparel and discount variety sectors constitute 14% of rent and the retail mix should be less affected by growth in online competition from Amazon and other disrupters.

SCP is expected to yield 6% in FY18, according to consensus forecasts. Do not expect SCP to shoot the lights out on yield or capital growth, but another double-digit total return in FY18 and FY19 is likely as the well-run SCP continues to optimise its tenant mix, manage expenses and explore value-accretive acquisitions.

Unlike the proposed Coles demerger, it made sense for Woolworths to spin out unrelated assets with low synergies into a standalone AREIT and give it a life of its own. Like the best demergers, SCP has been good for Woolworths and shareholders in the new entity.

Chart 3: Shopping Centres Australasia Property Group

Source: ASX

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