Merrill Lynch has issued a very strong “sell” recommendation for Wesfarmers following the company’s $2.5 billion rights issue to help fund its $18 billion aquisition of Coles.

In a note to clients, Merrill Lynch said while the capital raising was “the right thing to do” it was a “suboptimal solution”. As a consequence Merrill said “sell Wesfarmers – the risks are now too high”.

Merrill Lynch, along with Credit Suisse and Morgan Stanley aren’t involved in the Wesfarmers’ fund raising underwriters group. That includes ABN AMRO, Deutsche Bank, Goldman Sachs JBWere, JPMorgan, Macquarie Capital Advisers and UBS.

So Merrill’s who haven’t been a big supporter of Coles or the Wesfarmers takeover, can discuss the merits with a great deal more freedom. Which it has done:

To be up front, we think that Wesfarmers is undertaking the correct strategy in raising equity rather than pursuing debt renegotiation. However, we believe that Wesfarmers has compromised itself and is in a very poor position – which it is attempting to work its way out of at a very high cost.

It needs remembering that only 9 months back, Wesfarmers’ intended equity exposure to Coles was to be limited – to only $5bn for Target and Officeworks (100% WES) and only $2.0-2.5bn for Food & Liquor and Kmart. The other $13bn (for F&L and Kmart) was to be financed by private equity and non recourse debt.

When the debt markets “melted”, Wesfarmers elected to take on the extra $13bn – because it saw its corporate debt as being much cheaper than non recourse debt. That its corporate debt cost is now higher than its cost of equity is almost an unbelievable situation. We estimate Wesfarmers cost of equity to be 12% (pre tax).

And what is worse – Coles is broken … and deteriorating … Certainly that is our interpretation after viewing today’s numbers. To put in context, Food & Liquor delivered 3.2% comp sales growth in 3Q08 with 4.5%inflation – implying real growth of negative 1.3%. And that is compared to this time last year when we estimated Coles real growth to be negative 4%.

Coles is going backwards from an already disappointing trading position. And Kmart and Officeworks are also performing poorly … off very low bases.

Sell Wesfarmers – the risks are now too high.

In contrast Citigroup was more positive in its note to clients:

The deal removes refinancing as a risk factor and now the focus will turn towards the retail recovery. The signs from WES’s 3Q08 sales are positive for both Coles and Kmart, with improved sales relative to industry growth. We maintain a positive view about the turnaround potential at WES.

Retailing improves – Food & Liquor and Kmart have shown solid sales improvements in 3Q08 compared with the last reported result in 4Q07. While market share still declined, the growth is converging towards industry levels. Bunnings had an outstanding result with an acceleration in growth relative to its rivals.

Retail turnaround in focus – WES shares should now trade based on confidence in the retail turnaround. While macroeconomic headwinds persist, improved gross margin management and cost reductions at Coles will provide EBIT margin expansion over the next 12 months.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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