Author: Colin Twiggs

Stock: Wesfarmers Ltd
Symbol: WES
Exchange: ASX
Financial Year-end: 30 June
Latest price: $51.34
Market cap: $58.1 billion AUD
Date: 11 September 2018

Sector: Consumer Staples
Industry: Food & Staples Retailing
Investment Theme: Dividends & Growth

Company Profile

From its origin in 1914 as a Western Australian farmers’ cooperative, Wesfarmers has grown into Australia’s largest listed conglomerate. Headquartered in Perth WA, Wesfarmers’ businesses span the retail and industrial landscape.

Retail delivers the bulk of group earnings: 88% of FY18 EBIT after allowing for sale of Resources. Operations include 809 Coles supermarkets; 711 convenience stores; 228 Kmart discount department stores and 256 Kmart Tyre & Auto centres; 187 large- and 116 small-format Target apparel and homewares stores; 899 Liquorland, 1st Choice and Vintage Cellars liquor outlets; 88 hotels; 165 Officeworks office supplies stores; and 259 Bunnings home improvement warehouses, 78 smaller format stores and 32 Trade outlets across ANZ.

The Industrials division includes chemicals and fertilizers, gas processing and distribution, industrial and safety products and coal-mining (sold in August 2018).

Markets & Competitors

Woolworths is Wesfarmers’ largest retail competitor, operating more than 1000 supermarkets, 183 Big W discount stores, and more than 1500 liquor outlets. Competition from Woolworths and Aldi (460 stores) has exerted pressure on Coles’ margins: EBIT fell to 3.8% of Revenue in FY18, compared to 4.1% in FY17.

Bunnings is the jewel in Wesfarmers’ crown, with the largest market share (30%) in the Australian hardware/home improvement/DIY sector⁴. Competing retailers include Home Timber & Hardware and Mitre 10 chains, as well as a large number of independents. Woolworths, through their Masters joint venture with US home improvement giant Lowes, tried to challenge Bunnings’ market dominance but failed dismally, ending in Masters closure and a $3.25 billion write-down.

Kmart and Target were merged under a single head of Department Stores (Ian Bailey to replace Guy Russo in November 2018). Some Target stores were rebranded as Kmart while others were closed due to their poor performance which resulted in FY16 $1.27 billion and FY18 $0.3 billion impairment charges before tax¹.

Officeworks dominates the office supplies and stationery market but faces competition from Amazon with the launch of its online business supplies website.

Wesfarmers also hold a 25% stake in BWP Trust, a listed REIT which owns 79 Bunnings warehouse properties, 2 of which are now vacant, with Bunnings relocating some stores to former Masters premises.

Segments

Contribution to group EBIT by segment:

Acquisitions and disposals will significantly alter composition of the group in FY19.

Acquisitions and Disposals

On 16 March 2018, Wesfarmers announced their intention to spin-off Coles as a separate ASX-listed company with an independent board, to be completed in FY19. Wesfarmers would retain a minority ownership interest (up to 20%) and a substantial ownership stake in Flybuys (supporting Wesfarmers’ & Coles’ data and digital initiatives)².

Apart from the Coles spin-off, in recent months Wesfarmers shed a number of smaller subsidiaries:

• Sale of 13.2 per cent indirect interest in Quadrant Energy Holdings to Santos Limited, expected to net a profit of $98 million before tax (August 2018);
• Sale of Kmart Tyre and Auto Service business to Continental AG for $350 million, expected to net a profit of about $270 million before tax (August 2018);
• Sale of 40% stake in Bengalla thermal coal mine to co-owner New Hope for $860 million (August 2018); and
• Sale of Curragh coal mine in Queensland to Coronado Coal Group for $700 million, expected to net a profit of $110 million after tax (March 2018).

Wesfarmers earlier (May 2017) abandoned plans for an initial public offering of Officeworks after fund managers rejected the conglomerate’s $1.5 billion asking price because of weak Australian consumer discretionary spending and the prospect of increased competition with the arrival of Amazon in Australia.

Wesfarmers bought UK hardware chain Homebase for £340 million in February 2016, with the intention of rebranding the 265 stores in the UK and 15 in Ireland as part of the Bunnings group. After mounting losses, Wesfarmers threw in the towel, selling the entire UK and Ireland operation to turnaround specialist Hilco for a nominal £1³, with an FY18 after-tax impairment charge of $1.4 billion¹.

Michael Chaney in an interview with The Age explained:

Chaney was the chairman that signed off and despite everything contends he had never seen a more thorough investment analysis than had been undertaken on Bunnings UK. They had a base case set of projections and a downside case and it all looked very positive at the time according to Chaney. But a couple of fundamental mistakes were made subsequently after acquisition of Homebase home improvement network of stores including the removal of 150 senior managers.

“One was moving out the senior management and replacing it with our Australian experts and the second was getting rid of a lot of the products and the franchises because they didn’t suit the Bunnings model,” says Chaney. By way of example the Australian interlopers jettisoned Laura Ashley from the home decorator product line up – and British women voted with their purses.

It was the success of the Australian model and its management that blinded the higher ups inside Wesfarmers to the fact that these guys didn’t know better what the UK customers wanted. Wesfarmers got caught in the hubris trap.

Financial performance

Revenue Growth

Revenue growth stalled in FY18.

Coles revenues grew by 0.4% to $39.4 billion in FY18 but EBIT margins declined to 3.8% (FY17: 4.1%). Food & Liquor (incl. hotels) comparable sales grew 1.1%, while headline sales grew 2.1% to $33.6 billion. Convenience stores fell 6.1% to $5.8 billion in FY18 due to lower fuel sales.

Bunnings (Australia & New Zealand) same-store sales grew 7.8% in FY18 (FY17: 7.3%) while total revenue increased 8.9% to $12.5 billion.

Kmart achieved comparable sales growth of 5.4% in FY18 (FY17: 4.2%) while total sales grew 8.0% (FY17: 7.9%). Target comparable sales growth continued to decline, -5.1% in FY18 (FY17: -14.9%) and total sales growth of -4.7% (FY17: -14.5%). Combined revenue was up 3.6% at $8.8 billion.

Officeworks does not provide same-store comparisons but revenue grew 9.1% to $2.1 billion. This includes the opening of six new stores and online enhancements, including 2-hour click-and-collect, to combat competition from Amazon.

In the Industrials division, Chemicals, Energy & Fertilizers (CEF) revenue grew 11.7% in FY18 to $1.83 billion; Industrial & Safety declined 1.5% to $1.75 billion; and Resources (now sold) declined 3.3% to $1.69 billion after Curragh mine was sold in March 2018.

Margins

There were substantial impairment charges in FY16 and FY18. If one excludes these significant items, net margins stabilized at 4.2% in the last two financial years.

FY16 includes the following significant after-tax items: $1,249 million non-cash impairment of Target; $595 million non-cash impairment of Curragh; and $102 million of restructuring costs and provisions to reset Target.

FY18 includes an after-tax impairment charge and loss on disposal of $1.4 billion in respect of Bunnings/Homebase UK; $300 million non-cash impairment of Target; and $123 million gain on disposal of Curragh.

Return on Capital Employed

Wesfarmers are known for their disciplined capital budgeting and have demonstrated their willingness to shed underperforming assets.

Comparing return on capital (ROCE) to the actual allocation of capital, Coles is the elephant in the room, with ROCE of 9.2% in FY18 while absorbing almost 64% of group capital.

Return on capital employed by Department Stores and Resources is inflated by impairment charges in FY16 and FY18, while the Bunnings/Homebase UK misadventure is excluded from the above capital allocation.

Department Stores and Officeworks are unlikely to form part of the group’s long-term plans but there is little opportunity for a sale at present. Target faces a declining market, while Amazon is expected to challenge Officeworks dominance in office supplies and stationery.

Industrial & Safety also failed to achieve meaningful returns on capital. With Resources gone, that leaves Bunnings and WesCEF as the likely last divisions standing.

Earnings per share

Earnings per share declined in FY16 and FY18 because of impairment charges.

Dividends were maintained at 223 cents in 2018 (2017: 223 cents) and are fully franked.

Cash Flow

Free cash flow is reasonably strong despite recent losses.

Capital structure

Net debt is relatively low at 15% of equity and should improve further with post year-end disposals.

Weaknesses

Conglomerates used to dominate stock market listings several decades ago but inefficient management structures and poor capital allocation led to their almost complete extinction.

Coles revenues are resilient through the economic cycle but margins will remain under pressure from Woolworths/Aldi competition.

Bunnings is susceptible to fluctuations in the property cycle, with current declining home prices a warning sign.

Department Stores are susceptible to the economic cycle, while Target also faces a shrinking market.

Officeworks can expect fierce competition from Amazon.

Valuation

We expect that the Coles spin-off will realize $18 billion at an EBIT multiple of 12 (Credit Suisse estimate $19.4 billion). We value the remaining divisions at an EBIT multiple of 8 (before tax cost of capital of 12.5%) apart from Bunnings at an EBIT multiple of 10, giving a total value including Coles of $36.60 per share.

With dividends of $2.23 (a 4.3% yield) estimated to grow at 4% in the long-term, we project annual investor returns of 8.3%, or 10.2% after allowing for franking credits.

Technical Analysis

WES broke through resistance at $50 after lengthy consolidation above support at $40. Momentum rose to 22.6% while Trend Index held above zero since November 2016.

Breakout above $50 was followed by retracement to test the new support level. Rising troughs on 21-day Trend Index indicate that respect of support is likely.

Conclusion

Hold. Wesfarmers has indicated that the Coles spin-off will be completed by November 2018. It would make sense to wait for the spin-off before deciding whether to invest further or divest.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above company.

Sources

¹ FY18 Results Presentation
² Presentation, 16 March 2018
³ BBC News, 25 May 2018
⁴ Analyst Note, Johannes Faul, 15 August 2018, Morningstar