In March, Australian retail giant Wesfarmers (ASX: WES) announced to the ASX that it will sell most of Coles and would list the shares on the stock exchange as a separate company.

Investing in ‘special situations’ is not a strategy I use every day at Rask Invest but I can’t help but start licking my lips when a company splits its operations. Why?

It can unlock serious value for investors.

To Coles And Back Again

Wesfarmers has owned Coles supermarkets since 2007, when it paid $19.3 billion for the then-struggling retailer.

Because Coles is a high volume and low margin type of business it accounts for the majority of the capital in Wesfarmers but produces just 34% of profit. With the economy riding high and Amazon now in Australia it makes sense to at least consider selling Coles.

Wesfarmers also owns Bunnings, Target, Kmart, Officeworks, some pubs and fuel stations, and a few other businesses.

Chances are you will have driven past, or paid money to, a Wesfarmers store this week. (Bunnings gets me every time!)

Build It Up To Break It Down

In the past, conglomerate companies like Wesfarmers were very popular. They would buy part of a company — or the entire operation — and let it generate cash flow for the large holding company.

After they buy a new business they might cut some costs from head office, take on debt or invest extra cash to stimulate growth in the acquired company.

That’s exactly what Wesfarmers did to Coles 10 years ago, a time when some pundits said it would fail completely. But Wesfarmers knew better. It went ahead and completed the biggest-ever takeover in Aussie M&A history.

In the decade since, Coles has powered ahead, stealing share from Woolworths (ASX: WOW). And despite the looming threat of Amazon, Kmart has dominated Woolworths’ Big W and Bunnings knocked out Masters home improvement stores within a matter of five years.

But more recently Wesfarmers’ stellar track record has been called into question. A complete failure to expand Bunnings in the UK saw the company’s share price come crashing down in February.

Sales Create Opportunity

In the past month Wesfarmers has bounced back after it was revealed the sale of Coles could unlock $12 billion of cash and debt capital for the company.

Analysts from Citigroup were reported in AFR as saying the sale of Coles, the Bunnings UK and Ireland businesses, and the Curragh coal mine will afford Wesfarmers $12 billion of play money.

Citi even went so far as to say that Wesfarmers could lodge some bids for telco TPG Telecom (ASX: TPM), global pallets business Brambles(ASX: BXB) or paints company DuluxGroup (ASX: DLX).

I doubt they’ll be in a rush to do anything because the ‘new’ Wesfarmers business will likely be more cashed up and more profitable and growth-oriented than it is today.

I wouldn’t be surprised to see the new Wesfarmers/Bunnings business trading on the ASX at more than 20 times its earnings/profit if current conditions persist. That could mean a valuation in excess of $30 billion.

Coles’ Valuation

Conversely, the Coles business, which will also include First Choice Liquor and Liquorland, will be a defensive, probably debt-heavy and dividend-paying business.

The split is not expected to finalise until the 2019 financial year, so arriving at a valuation for either business relies on a few assumptions.

However, given that Coles should achieve a reliable operating profit (EBITDA) in excess of $2 billion and pay a decent dividend I think its valuation could be around $20 billion (at the upper end).

What now

If we combine the estimated Coles and Wesfarmers/Bunnings valuations we get a valuation around $50 billion, which is close to the current market price of Wesfarmers.

However, this analysis is just the beginning. And given the details of the deal are a little hazy it is too early to act. Nonetheless, the potential for a near-term split of Coles and Wesfarmers could create a great buying opportunity for ASX investors.

I’m doing deeper research on the deal for Rask Invest to determine if there is potential for both a consistent fully-franked dividend and long-term capital growth from holding either company.

I have found that it tends to be the smaller company (e.g. BHP’s South32 spinoff) that performs better from these divestment opportunities in the near term.

However, as a long-term investor focused on growth and tax-effective dividend income, I’m looking squarely at Wesfarmers/Bunnings post-demerger — not Coles.

In the meantime, I hope for my sake that the Wesfarmers’ share price stops going up!

Owen

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P.P.S. This article contains general financial information only. That means the information does not take into account your objectives, financial situation or needs. Because of that, you should consider if the information is appropriate to you and your needs, before acting on it. In addition, you should obtain and read the product disclosure statement (PDS) of the financial product before making a decision to acquire the financial product. Owen Raszkiewicz does not have a financial interest in any company mentioned in this article.

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