Wesfarmers Gearing Ready to Pounce

Wesfarmers' management is significantly altering the group's DNA with the proposed demerger of grocer Coles, closing sometime in fiscal 2019 if approved by shareholders. There are aspects to like in the demerger, which will separate Coles from the core Bunnings home improvement retail stores. The two businesses—accounting for about two thirds of group EBIT—have very different growth prospects, and the split will provide the residual group with a greater capacity to engage in impactful M&A transactions given the smaller size and stronger balance sheet of Wesfarmers postdemerger. However, we can't see a material value uplift, as we don't expect the cash flows generated by the existing businesses to be enhanced by simply splitting them apart. Although limited upside potential to our fair value estimate of Wesfarmers exists in the order of 4% on our preliminary assessment, it is mainly from a lower cost of equity for Coles than for Wesfarmers today. Pending firm capital structures and the finalisation of our moat ratings for the new entities, we reiterate our fair value estimate of AUD 37.50 per current Wesfarmers share. In our base case, we continue to expect Bunnings to grow strongly in Australia and New Zealand, but we believe the market is much more optimistic on Bunnings' prospects and is pricing it close to perfection.

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