Income Report / Income Report; Why we don’t like Wesfarmers (ASX: WES) or Coles (ASX: COL) & an update on ASX: AXLHA

By Market Matters 21 November 18

Income Report; Why we don’t like Wesfarmers (ASX: WES) or Coles (ASX: COL) & an update on ASX: AXLHA

Market Matters Income Report 21st November 2018

A busy day on the desk this morning so a late Income Report…although pleased to see the market test below 5600 and bounce strongly at time of writing. One day certainly does not make a summer however a strong close this afternoon would look technically bullish.

At time of writing, the market is trading down 35points at 5636 after hitting a low this am at 5594.

ASX 200 Chart

For the week, the MM Income portfolio lost -1.06% against a backdrop of the ASX which fell  -2.78.%. For the financial year to date, the portfolio is down -1.74%  versus its benchmark of RBA cash rate +4% which sits at +2.14%  while the ASX 200 accumulation (including dividends) is down by -6.66%. Since inception (5th July 2017) the portfolio has added 3.18% versus its benchmark of +7.58%. The biggest drag on the week came from both Alumina (AWC) and Super Retail Group (SUL) was also weak

Wesfarmers & Coles Demerger – why we don’t like either one

Today is the first day of trade for the separated Wesfarmers / Coles businesses however they still are linked to a degree with WES retaining 15% of Coles and they both hold 50% each of Flybuys. Wesfarmers (ASX: WES) is trading down $12.50 at $31.79 and Coles (ASX: COL) is trading at $13.05 which means shareholders are up on day 1 in a weak market.

WES shareholders (we’re not) will get 1 share in the new Coles entity for every WES share they hold – they then need to make a decision – to hold or sell those shares. WES will go from the diversified conglomerate that benefited from the stability of Coles earnings but suffered because they dragged on growth, to a more growth orientated vehicle looking for acquisitions. Coles on the other hand will now be a vehicle that generates earnings that are stable but with very little growth, particularly given the large capital expenditure program they are likely to roll out.  

Both WES and Coles are good businesses with good assets, however they both have near term headwinds which make us negative on both;

Coles (ASX: COL); Earnings here will be 90% Coles while the remaining will be Flybuys, Hotels, Liquor and a few other bits and pieces . The issue for Coles is the requirement to build two new distribution centres to help with their logistics network. WOW has a better distribution network than Coles and as the onslaught of international players (AMZN, Kaufland, Costco, ALDI, Lidl) and intense domestic landscape (WOW, MTS IGA, 7-11s) all modernise their supply chain metrics to maintain/enhance competiveness, things will get tougher. Given this outlook for capex, it seems very likely that Coles will need to draw on debt to fund dividends over the next few years. We have no interest.

Wesfarmers (ASX: WES);  Housing related stocks have been under significant pressure in recent times. Fletcher Building (ASX: FBU) the latest to downgrade earnings, Boral (ASX: BLD) is down ~33% over the past 12 months while property stocks exposed specifically to the residential sector have been hit hard – just look at Stockland (ASX: SGP) which has fallen by around 22%. Last week Morgan Stanley wrote a good note on WES (Bunnings) following the Dulux (ASX: DLX) result. We covered it at the time however in essence they suggested that after Wesfarmers recently ceased disclosing quarterly sales figures, looking at Dulux results gave a good read through for Bunnings, in so far as paint is a big driver of foot traffic and sales of other associated products tend to follow.

In short, DLX's core ANZ business delivered 3.9% revenue growth in the 2H (ended Sept) a slowdown from the 5.7% in the 1H. DLX indicated that market growth slowed from 4% during the 1H to 2.5% for the FY18 which implies just 1% growth in the 2H.

A call on WES is to a large degree a call on Bunnings. The market continues to look backwards in terms of their phenomenal track record of growth however we simply think that the trends playing out across housing and retail generally is too big of a red flag for WES.

We have no interest in WES or COL at this stage.

Wesfarmers (WES) Chart

There was actually an interesting paper out from Grant Samuel that was part of the Independent Expert’s Report for the WES-Coles demerger for anyone wading through the riveting 237-page Scheme Booklet! They looked at the relative performance of Australian companies that have undertaken demergers since 2000. The analysis is not perfect however is provides a reasonable look at the performance of stocks from both sides of the ledger – and ultimately the conclusion is that some work and some don’t.

It’s a hard conclusion to come to though, as there is clearly no counterfactual argument, simply because it is not possible to measure what the share prices would have been had the demergers not occurred. Anyway the data is below for what it’s worth and it summarises the combined share price performance of the parent company and the demerged entity relative to the S&P/ASX 200 index, from last close prior to announcement to three months, one year and two years after the date the demerged entity was listed on the ASX.

Source; Grant Samuel

Axsess Today Simple Bond (ASX: AXLHA)

**A reminder, this is general advice only and does not take into consideration any individuals personal circumstances**

The bond (ASX: AXLHA) and the head stock (ASX: AXL) remain suspended from the market. We have the bond (not the stock) in the Income Portfolio and I own it personally. The bond has continued to pay distributions with another one due on the 20th December for $1.62 (paid on the 31st Dec). The business continues to operate while its suspended from the ASX and the company is clearly working hard to resurrect itself. While far from an ideal situation, bond holders are in a better position than equity holders.

The company wrote to bond holders recently asking  to change one of the conditions around interest cover. In simple terms, they want bond holders  to agree to amend the covenant that relates to the interest cover ratio. In other words, when bond holders lent the company money, one of the conditions was that their earnings before interest and taxes was at least 2x their interest expense over the same period. 

Given the issues in the business, earnings are likely to be lower. To ensure that the business can continue to operate and not be in default of the conditions within the bond, they have asked bond holders to agree to a change down to 1.75x. So, earnings before interest and tax will now need to be 1.75x the interest expense over that period if the bond holders agree to it.

While each individual may have their own take on this, and I certainly can’t speak for others, I’ll be agreeing to the amendment for my holding, simply because it will give the company a better opportunity to right itself. As a bond holder, the best outcome here is that the waiver goes through, it allows AXL to raise additional capital (via equity) and the company continues to operate, although the share price is likely to be hit hard, and the equity raise would be big and at a significant discount.

From the releases provided by the company, it seems progress is being made on the strategic review with the (closure of Canada and business lending, appointment of an interim CEO and ongoing negotiations with lenders). More information about funding now the key.  

75% of bond holders need to agree to the change and it’s my understanding that some of the larger holders will do so, however it’s hard to be sure. On page 11 of the Notice of Circulating Resolution and Explanatory Memorandum  states that the Syndicated Facility and the series II notes have agreed to this change, which means that all other lenders have already agreed. The listed bond holders are the last piece of the puzzle here.

The timetable is as follows…


A strong close today will be bullish for the market technically after 5600 was breached this morning

We have no interest at this stage in Coles or Wesfarmers

We will give AXL the opportunity to resurrect themselves by agreeing to the change in interest cover ratio

Have a great day!

James & the Market Matters Team


Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.


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