Better buy: Woolworths Group Ltd or Wesfarmers Ltd?

Beginning its life in Western Australia in 1914 as a farmers’ cooperative, Wesfarmers Ltd (ASX:WES) has grown into a diversified conglomerate and one of the biggest companies currently listed on the ASX. While still predominantly a retail business, operating well-known Australian brands like Coles, Bunnings, Officeworks, Target and Kmart, Wesfarmers has also branched out into industrials through its interests in chemicals, energy, fertilisers and coal.

In its results announcement for the half year ended 31 December 2017, Wesfarmers reported a 54.2% decline in EBIT to $1.1 billion. Adjusting for a number of significant write downs and impairments to its Bunnings brand in the UK and Ireland and its Target brand in Australia, underlying EBIT was still down 3.3% to $2.4 billion.

This decline was driven mainly by the poor performance of the Coles supermarket business. While the Bunnings Australia and New Zealand division delivered strong EBIT growth on the prior comparative period, up 12.2% to $864 million for the half, EBIT for the Coles brand was down 14.1% to $790 million.

Wesfarmers blamed Coles’ poor performance on a number of factors, including the impact of investments made to improve the company’s customer offer, lower financial services earnings due to the sale of its credit card receivables in FY17, and lower fuel earnings.

And while Wesfarmers maintained that Coles’ underlying transaction growth and sales momentum for the half was strong, it still seems telling that the Group has subsequently announced its intention to demerge the supermarket chain from its broader business. Wesfarmers claims that Coles is now a mature business capable of independent self-governance, although sceptics might wonder whether the Group decided that after its recent weak performance the Coles brand was becoming too much of a drag on its bottom line.

However, if the planned demerger goes ahead it could still end up being good news for shareholders in Wesfarmers, who will receive shares in the new Coles company in proportion to their current holdings. And demergers can often find a way of unlocking value for both the continuing conglomerate and the newly created company.

In this case, Wesfarmers’ might deliver a better result to its shareholders by continuing with its stronger-performing businesses like Bunnings, Officeworks and Kmart. Coles, on the other hand, might benefit from more focussed, independent management.

One company watching these developments closely will be Wesfarmers’ key rival in the Australian retail space, Woolworths Group Ltd (ASX:WOW). Woolworths delivered strong first half FY18 financial results, growing EBIT from its continuing operations by 9.9% on the prior comparative period to $1.4 billion.

Woolworths is currently enjoying something of a turnaround in fortunes, especially now that its core supermarket business no longer has to absorb the heavy losses incurred from the company’s failed foray into the home hardware sector through its (thankfully) discontinued Masters brand.

But just as management at Woolworths were starting to gain some confidence again, they now have to contend with the real possibility of fending off an attack from a nimbler and more focussed Coles business. It all spells interesting – and possibly more competitive – times ahead for the Australian retail sector.

Foolish takeaway:

Based on recent financial performance, the smart money would have to be on Woolworths continuing to outperform Wesfarmers. But Woolworths’ change in fortunes has really only come about because it has basically done what Wesfarmers is planning to do, only in reverse.

After suffering continued losses from its Masters brand, Woolworths finally rid itself of its failing home hardware business and has gone back to focussing on its supermarket brand. By demerging Coles from its other divisions, Wesfarmers intends on creating a similarly streamlined independent supermarket company.

Shareholders in Wesfarmers may be thinking that, if an unburdened Woolworths can turn its fortunes around so markedly, maybe Coles can too.

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Motley Fool contributor Rhys Brock has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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