The Australian conglomerate Wesfarmers (ASX:WES, Financial) is demerging its largest company within its portfolio, and from the day it was purchased it has been an example of the axiom, "The price you pay for an asset determines your investment return." Which is what Warren Buffett refers to when he says, "Price is what you pay and value is what you get."
Summary:
- Australian conglomerate Wesfarmers demerges its largest holding company, Coles.
- Ten years after Wesfarmers purchased the Coles Group for AUD$19 billion it is only estimated to be worth AUD$19 billion by Credit Suisse.
- Wesfarmers is masking the real earnings of Coles in its annual reports and it is looks like a coming train wreck.
Wesfarmers’ chief executive Rob Scott announced a demerger of Coles from Wesfarmers’ by spinning off Coles as a listed ASX independent company.
"Therefore a demerger is a logical way of separating the businesses and giving our shareholders the opportunity to have a direct interest in Coles,” Scott said.
Wesfarmers’ will retain 20% ownership of the newly listed entity, and the remaining 80% ownership will be transferred to current Wesfarmers shareholders via newly issued shares.
The Australian Financial Review reported that Scott said every business in Wesfarmers was theoretically for sale, but a demerger was the best way of separating Coles from the Wesfarmers business without incurring capital gains tax.
So you will have the opportunity to buy an ownership share in Coles in the near future (six to eight months according to Scott), if you aren’t already a Wesfarmers’ shareholder. But should you?
It was reported in the Financial Review that Credit Suisse put the value of Coles at $19 billion (All amounts in Australian dollars & Source).
Amusingly, that was the same price it paid for Coles in late 2007.
The most optimistic valuation I calculated for Coles was $13 billion, but once the optimistic assumptions are removed from the equation the valuation drops like a stone.
I’m not surprised by Credit Suisse’s excessive valuation. If I wanted to handle the demerger of a company the size of Coles and earn large handsome profits, I too would butter up Wesfarmers’ management by publicly announcing an excessively high valuation for Coles.
But what value is Coles’ worth?
Wesfarmers reports Coles’ income on an Ebit basis, but it does something else you should know.
It adjusted reported capital expenditure spent each year using accrual account practices.
For instance, in 2017, $811 million was the reported amount of capital expenditure spent, but that number was reduced due to movement in accruals. Once the accruals were added back, the amount rose significantly to $1.68 billion. So we have to adjust the reported capital expenditure for all six years.
Adding back the accruals is necessary as it isn’t necessarily a cash payment, and it would not appear in the cash flow statement. But the capital expenditures – stated as Plant, Property & Equipment – would appear as a line item under cash flow investing activities.
Not surprisingly, once adding back the accruals, Coles’ capital expenditures bring it back in-line with the capital expenditures of its nearest competitor, Woolworth’s.
Once the readjustment was made for the last six years, it resulted in the six-year average Ebit figure of -$803 million. All previous six-year Ebit figures were negative.
Coles’ supermarkets before Wesfarmers purchased them in late 2007 were severely lacking in investment, and the majority of stores were in bad shape. It was expected that large capital expenditures were needed to be invested by Wesfamers to get Coles’ supermarkets up to standard just to compete with Woolworths.
Also consider that in late 2007, Wesfarmers paid $19.4 billion for the Coles Group.
What did it get for the $19.4 billion? Here are some back of the envelope calculations.
Wesfarmers 2007 Annual Report
This is a snapshot of the asset and liability values of the Coles Group when Wesfamers purchased it in 2008.
The carrying book value stated above is $2.6 billion. Using a (modified) enterprise value (EV) method (assets + liabilities), the Coles Group was worth $16 billion.
The reproduction value (RV) method is similar to book value but revalues the assets to reflect their truer value, and is reflected above in Note 27 under the column "recognised on acquisition," which is the figure used here: approximately$5.8 billion.
Let’s compare the return on valuation method ratio for all three valuation methods.
Reported net profit was $748 million in 2007 (a 32% drop in net profit from the previous year, according to the Coles Group 2007 annual report).
- BV return is 29%.
- EV return is 4.70%.
- RV return is 3.90%.
- Actual purchase price return on 19.4 billion is 4%. (Percentages rounded.)
Before a cent was invested in the Coles Group to restructure and refurbish it, Wesfamers was only earning 3.90% on its initial investment.
Let’s now compare Coles’ valuation after 10 years, using Wesfarmers' reported numbers in its 2017 annual report.
BV = $16.7 billion
EV = $35.4 billion
RV ≈ $18 billion
Reported Net Segment Income BT $1.609 billion.
BV return is (1609 / 2007 BV) = 62%
EV return is (1609 / 2007 EV) = 10%
RV return is (1609 / 2007 RV) = 28%
Original purchase price return is (1609/19400) = 8.20%
Therefore, without a single cent of external investment, after 10 years, the return increased by 4%.
That is quite a dismal return on $19 billion, considering the inflation average of 3%, and that's without adding in the capital expenditure spent on restructuring and refurbishment of all supermarkets owned by Coles.
In part 2, I'll reveal the secret to calculating the capital expenditure maintenance calculation that Warren Buffett himself refers to in his annual reports, which he calls owner-earnings, as applied to Coles' capital expenditures above.
