Barely a decade has passed since Wesfarmers Limited [ASX:WPL] made its successful bid for retail juggernaut, Coles Group.
At the time, the $22 billion price tag made it the biggest takeover in ASX history. It also put an end to a miserable time for the Coles board.
The struggling Coles had already been a target of the famed US private equity group, Kohlberg Kravis Roberts (KKR).
Having first low-balled Coles, KKR followed up with a higher bid. At $15.25 a share, though, KKR’s final bid fell short with Wesfarmers coming over the top at $17.
Originally, Wesfarmers had no plans to go it alone. At its side were two other private equity groups. When they failed to raise the finance, though, they quietly slipped out the back door.
Wesfarmers had two choices. It could abandon the takeover…or complete the deal by itself.
Wesfarmers had to raise capital at a heavily discounted price to help finance the deal. It also had to pump billions into Coles to turn it around.
With Wesfarmers announcing last month that it now plans to spinoff Coles, the jury is still out on who won from the deal.
I’m sure the pragmatic KKR crunched the numbers and couldn’t make the deal work above its final bid. In their eyes, Wesfarmers simply paid too much to buy Coles.
It won’t be until the recreated entity trades on the ASX again that we will know its worth. The spinoff is due sometime in the 2019 financial year.
It could be that after all the money Wesfarmers has put in — including the discounted rights issue — it might only break even on the deal.
How will Wesfarmers use their capital?
What the spinoff brings back into focus is how companies best use their capital. And this is how Wesfarmers is selling the deal.
Although Coles generates around one third of Wesfarmers’ earnings, it ties up around 60% of its capital. By separating Coles, it should allow Wesfarmers to better use its capital elsewhere.
It also brings to light how the market values company structures. At one time, the market put a premium on conglomerates. That is, holding companies that own a swag of businesses.
The theory is that the different businesses can thrive at different times in the cycle. Because of that, it can help add a buffer to earnings.
The trouble comes in valuing the entity as a whole. Different companies come with different cashflows and margins. They also have different product life cycles.
Plus, investors who only want to invest in one of the businesses have to invest in all its other businesses as well.
That means for Wesfarmers shareholders, they own a coal business (although this is soon to be gone), a stationery chain, as well as hardware stores in the UK. Not, you might argue, a natural mix.
The other issue though, is what Wesfarmers will do with all that extra capital. Sure, Bunnings in Australia continues to print money. Yet at the same time, its UK counterpart is tearing it up.
Some analysts are no doubt already making bets on when Wesfarmers will bail on the project. The last thing it wants to do is have its own Masters experience. Neither, of course, will its shareholders.
And of course, there’s nothing to guarantee that any new acquisition will make a decent return either. That’s why after initially rallying on the spinoff news, Wesfarmers share price has since run out of sizzle.
The other question is what Wesfarmers will do with its remaining holding in Coles. It says that it will retain a 20% holding.
This no doubt blocks someone else from making a bid for Coles. It also means that things like its loyalty programs can continue as they are.
What it also means is that Wesfarmers can collect a stream of dividends from Coles. When spun off, Coles should have a strong balance sheet and the capacity to pay a handy yield to its shareholders.
The good thing for us as income investors, is that the demerger offers another choice. That is, the higher returns on Wesfarmers existing businesses (excluding the UK and Target). Or the more steady, yet capital heavy, Coles supermarket business.
The Wesfarmers conglomerate structure will continue after the split. The debate about whether that most benefits its shareholders will also continue as well.
All the best,
Editor, Total Income