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Has Wesfarmers got it right?

Has Wesfarmers got it right?

In writing Value.able I wanted to explain return on equity  almost as much as I wanted to introduce the idea of future intrinsic value estimates and Walter’s intrinsic value formula.

From Value.able, PART TWO, The ABC of Return on Equity:

Return on equity is essential for value investors for so many reasons and Wesfarmers purchase of Coles was a great case study:

“In 2007, Wesfarmers had Coles in its sights. In that same year, Coles reported a profit of about $700 million. In its balance sheet from the same year, Coles reported about $3.6 billion of equity in 2006 and $3.9 billion of equity at the end of 2007. For the purposes of this assessment we will accept that the assets are fairly represented in the balance sheet. Using only these numbers we can estimate that the return on average equity of Coles was around 19.9 per cent.

Importantly, Coles has been around a long time, is stable, very mature and established and supplies daily essentials. While its prospects may not be exciting, there is the possibility that Wesfarmers may improve the performance of the Coles business.

So the target, Coles, is a business with modest debt and $3.9 billion of good-quality equity on the balance sheet that generated a 19.9% return. The simple question is: What should Wesfarmers pay for Coles? If it gets a bargain, it will add value for the shareholders of their business. If it pays too much, it will do the opposite – destroy value and perhaps its reputation.

Now, if you were to ask me what to pay for $3.9 billion of equity earning 19.9 per cent (assume I can extract some improvements), I would start by asking myself what return I wanted. If I were to demand a 19.9 per cent return on my money, I would have to limit myself to paying no more than $3.9 billion. If I was happy with half the return, I could pay twice as much. In other words, if I was happy with a 10 per cent return, which I think is reasonable, I could pay $7.8 billion, or two dollars for every dollar of equity. And finally, if I think that I could do a much better job than present management, I could pay a little more, $9.75 billion perhaps.

Now suppose you consider yourself much better at running Coles than the present Coles management. Remember, this is one of the motivators for acquisitions. Suppose you believe that you can achieve a sustainable 30 per cent return on equity. Assume you were seeking a 10 per cent return on your investment – a modest return by the way, but justified by the risks involved.

The basic formula to calculate what you should pay for a mature business, like Coles, is:

Return on Equity/Required Return x Equity
Using this formula the estimated value of Coles is:
0.3/0.1 x 3.9 = $11.7 billion

Even if I thought I was a brilliant retailer, I would not want to pay more than $11.7 billion for Coles. Given the risks, I may want a higher required return than 10 per cent. If I demanded a 12 per cent required return, I would not pay more than $9.75 billion (0.3/0.12 x 3.9 = $9.75).

I will explain this formula, which represents the work of Buffett, Richard Simmons and Walter in more detail in Chapter 11 on intrinsic value.

Of course, if we think that the balance sheet is overstating the value of the assets, the result would be a lower equity component and a higher return on equity. As Buffett stated:

Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures.

The result will be modestly different but the conclusion will be the same.

With around 1.193 billion shares on issue, the above estimates suggest Coles might have been worth between $8.17 and $9.80 per share.

Now, what did Wesfarmers announce they would pay for Coles? The equivalent of about $17 per share!

What do you think would happen to your return on equity if you paid the announced $22 billion for a bank account with $3.9 billion deposited earning 19.9 per cent? Your return on equity would decline precipitously to around 3.5%.

With that in mind I wonder whether the comments Wesfarmers were reported today to have made to The Financial Review (see image, I subscribe and think its great) were complete.  Of particular interest is the paragraph; “The way we create value to shareholders is to increase return on capital.  There’s no doubt when we bought Coles we bought a very big business with very low return on equity and that reduced the return on equity for the company.

Assuming the comments and statistics are correct, I would argue that the reason for the decline in Wesfarmer’s Return on Equity is not because Coles had a low ROE – as Wesfarmers are reported to have suggested – but because Wesfarmers simply paid too much for Coles. Do you agree or disagree?

What are your thoughts?

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 28 May 2012.


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. So WES overpaid for Coles 5 years ago, take that as given (and I agree it is an excellent case study). Where does that put me now when deciding if WES is a good company to invest in today? Surely Coles is still a good business even if WES paid too much for it (i’m not arguing it was a good investment for WES). The underlying ROE (ex goodwill) of Coles has probably improved under WES ownership and every marginal dollar WES invests in Coles is more likely to be earning the underlying ROE rather than the “purchase price” ROE. Coles still has much lower supermarket margins than WOW so there is still a significant prize to be had if the get those margins right. My question is: “Is the value destruction of the Coles purchase in the share price today?”
    When assessing ROE Buffett says he looks at the ROE ex goodwill because frontline management (as distinct from head office management) don’t get that goodwill to actually invest in the operations of the business. On that basis WES still has some great assets.

    • Buffett has also said he includes all the goodwill and reverses any amortisation that has reduced it – forcing the balance sheet to carry it at full cost. if the ROE stays low then arguably auditors cannot continue to justify the carrying value of the goodwill.

      • I agree Roger, but if the auditors didn’t require a goodwill write-down over the last 5 financial years why would they now when profits are improving?

        This ROE issue can be misleading at times. For example, suppose I set up shelf company XYZ and make an all scrip bid for COH at a 50% premuim to the current share price (ok you need to suspend reality here, the example is for illustrative purposes only). COH is a very high ROE business and probably ranks very highly on Skaffold. Post my bid, (presumably) the shares would trade back to where COH was trading pre the bid, the business would be the same, the shareholders the same, the management the same the name may have changed and XYZ would have to book a huge amount of goodwill on the balance sheet. Would XYZ rank differently on Skaffold then COH did?

      • Hi Roger,

        Where does buffett state that. I think Charlie makes a good point, especially when buffett talks about scott & fetzer.

        Think of it this way, if i wrote off all the goodwill tomorrow, the value of the business should not change (after the writeoff), no cash will ever leave the business as a result.

    • Hi Charlie,

      In regards to where WES is now you make a good point, things have changed since they took over Coles. However, if you look at Ash’s post below about the last 10 years worth of ROE figures you can see that the acquisition is still placing a bit of a burden on the ROE figures.

      Using the same technique i used to come up with the 1.64% return on incremental capital i can see that since then this has been getting better which is no doubt also seen by the fact that the total ROE figure is tracking up. However this is still only around 7-8% so there for not attractive to me and definitley not in the realm of “quality” as far as i am concerned. If i want a supermarket play i can look at Woolworths with its 25%-30% ROE.

      All of the above means that the low return on equity figure today is still impacted by paying to much for coles and that in a valuation approach that has ROE as a key measure, the intrinsic value will be impacted.

      I am not a fan of turn arounds and that seems to be the only story you could come up with i believe to warrant buying Wesfarmers. My opinion only of course.

      • Agreed Andrew,

        But it’s not a turn around,WES has to near on double profits before they become an investable position,

        My mirco caps that I like may be able to double profits but WES ?

        Much more likely that I will get a date with Marisa Miller.


  2. Roger,

    The beauty of numbers is they never lie, and always tell an interesting story about a company.

    WES over last 10yrs increased sales per share by 10.9% while EPS increased only by 5%. Less than half of sales! Over the last 5 years sales per share has increased by 16.7% while EPS REDUCED by 5.1%. That’s right WES is earning less per share today than 5 years ago even though sales per share is up 16.7%!!!. Reason being net profit margins have reduced from 9.8% to 3.5%. So all those down down sales campaign you see on TV is a worst management decision because it is coming at a cost of shareholder profits. If I was a shareholder I would be fuming. Sales are important but not at the cost of profits. I know it’s exaggeration but anyone can sell millions of $50 notes in exchange for $20 notes. That’s what WES is doing. Increasing sales only matters if it increases profits by more or at the very least an equivalent amount percentage wise. I have a feeling WES management will be setting their pay packages on amount of sales target they achieve.

    Let’s compare with it’s prime rival WOW.

    Sales per share over the past 10yrs up 7.4% while EPS up 14.9%. Over the past 5 years sales per share up 5.9% and EPS up 13.7%. Net profit margins were 2% in 2002 increased to 3% in 2007 again increased to 3.8% in 2011. Now as the owner of the business, I know management are working towards increasing shareholder value.

    I can go on forever, but you get the picture.

    • Sorry Hiten, I have to disagree with you. Numbers do lie. Just look at Hastie. And also, numbers can be misleading. For different industries, sectors and even companies, the same measure eg employee expenses can mean different things. Otherwise databases would do all the work and take the fun out of investing.
      Also, comparing Wesfarmers ROE and Sales pre Coles acquisition and post is like comparing apples to oranges. They had coal, fertiliser businesses as well as others and now Coles is half their business. The “down down” TV ads were to get market share, this is not a mistake, this is good.

  3. When I held Coles shares – I am glad they did.
    Back to the present – Wesfarmers Coles have upset their clients no end with their latest MY5 rip off – When my wife went online she wanted to select Jalna 1kg but Coles would only let her select 500gms so when she bought her favourite 1kg x 5 which is about $30 she got no discount and many people she talks to report the same – We have however now spent 70% in Woolies and 30% in Coles reversing the 60% buy ratio in Coles – as you can see smoke and mirrors but you can only fool some of the people some of the time

  4. As you mention Roger, Coles ROE was not low, i have been wondering when Wesfarmers would address what happneed to their ROE after the coles transaction and this appears to be the line.

    What happened? Well here is my take.

    Just quickly using Commsec (so take these figures as you want)
    In 2006/2007 Wesfarmers had $3502.9M in equity, the next year this shot up to $19,590M. In the meantime, their net profit went from $786.3M to $1050M.

    So the extra $16087.1M worth of equity resulted in an increase in profits of $263.7M or if i work it out correctly an return on incremental equity of around 1.64%.

    It is obvious as to the reason and it wasn’t Coles “low” return on equity but the amount of worthless goodwill on the balance sheet that is sittin gin there inflating the assets but not resulting in any kind of return. how did this happen, well they paid far to much as we all know.

    it is the equivalent of a politician trying to say they made a mistake without particularly blaming themselves or their party.

    • Lovely application of the philosophy Andrew: “Just quickly using Commsec (so take these figures as you want) In 2006/2007 Wesfarmers had $3502.9M in equity, the next year this shot up to $19,590M. In the meantime, their net profit went from $786.3M to $1050M. So the extra $16087.1M worth of equity resulted in an increase in profits of $263.7M or if i work it out correctly an return on incremental equity of around 1.64%.” Well done!!!

    • Nice Stuff Andrew,

      You don’t even need to be trouble yourself with the ROIC

      Below is WES ROE for the last 10 years from Etrade( Same data on comsec)

      12.2% 12.8% 17.1% 20.1% 27.5% 22.4% 5.4% 6.8% 6.3% 7.6%

      can you guess why they purchased coles?

      Wes was a good business before they got coles…..Not fantastic but good,

      It’s now terrible.


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