Citigroup says buy Coles Group Limited (ASX: COL) and sell Wesfarmers Ltd (ASX: WES)

Citigroup says buy Coles Group Limited and sell Wesfarmers Ltd

History has shown that the newly spun-off stock tends to outperform its parent over a 2-year period. Citi thinks there are other reasons why investors should back one and dump the other.

Brendon Lau

Brendon’s passion for shares started by accident in 2003 and he has worked in various roles around capital markets ever since as a trader, stock analyst and markets reporter with the Australian Financial Review. Most of his wealth has come from share investing than any other asset class, and that has given him the financial freedom not to work full-time, if he chooses to. Brendon is a medium to long-term investor who aims to hold positions for a year or longer and is focused on fundamental analysis, although he will occasionally use technical indicators to time his entries and exits. Brendon has an MBA from Melbourne Business School and is RG 146 certified. He lives in Melbourne with his wife, three kids and two dogs.

Published November 23, 2018 2:25 pm AEDT

The newest member of the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) index has found a new fan with Citigroup initiating coverage on the stock with a "buy" after Goldman Sachs made the same recommendation yesterday.

But that doesn't seem to be doing much for the Coles Group Limited (ASX: COL) share price, which only inched up 0.1% during lunch time trade to $12.76 when the top 200 stock benchmark is up 0.3% and its parent company Wesfarmers Ltd (ASX: WES) share price is powering ahead 1.3% to $31.74.

This could be the time to dump Wesfarmers and buy Coles, according to Citigroup.

Child outshines the parent

Fundamentals aside, history suggests that Citi may be on to something. The share price performance of the child entity (the business that got divested) tends to be better than the parent stock in the year or two post the demerger.

We saw that when Orica Ltd (ASX: ORI) spun-off DuluxGroup Limited (ASX: DLX) back in 2010 with both stocks more or less tracking each other in the first year of the separation before the DXL share price surged ahead to produce an 18% gain when the ORI share price fell nearly 2%.

A similar pattern emerged when BHP Billiton Limited (ASX: BHP) spun-off South32 Ltd (ASX: S32) in 2015.

Will it happen again for Coles?

Coming back to Coles and Wesfarmers, Citigroup thinks Coles is worthy of a "buy" as the stock is trading at around a 15% discount to archrival Woolworths Group Ltd's (ASX: WOW) share price.

This discount isn't justified in the broker's view as it believes the like-for-like sales gap between the two supermarkets to be a relatively narrow 50 basis points over the next 12 months as Coles' earnings before interest and tax (EBIT) margin catches up to Woolworths over the next five years.

Meanwhile, Citi has downgraded Wesfarmers' shares to "sell" from "neutral" following the demerger as the stock has gone ex-growth and is overly reliant on the slumping property market.

"In the absence of acquisitions, we see Wesfarmers as a low growth conglomerate with ~60% of earnings exposed to Australian housing, through Bunnings and Kmart," said the broker.

"Following successful divestments of several underperforming/capital-intensive businesses, the challenge of acquiring and integrating businesses is now ahead."

Foolish takeaway

I am inclined to agree that Coles presents a better medium-term stock to hold although I don't think we should write-off Wesfarmers just yet.

The conglomerate could swallow a decent size acquisition of up to around $3 billion without needing a capital raising and it could excite the market if it finds a target that would significantly lift its growth profile.

Furthermore, if history is any guide, there isn't any big-time pressure to switch from Wesfarmers to Coles as both stocks are likely to trade roughly in line with each other over the coming months.

In other words, if you already own the stock, I would hold on to both – at least for now.

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