S&P 500 target

My target for the current S&P 500 long-term advance has been 3000 for a number of years. The chart below explains the target calculation.

S&P 500 Target CalculationClick here to view a full screen image.

The Dotcom bubble retraced from a peak of 1500 to a low of 800. Readers who are familiar with my method will know that on a short- or medium-term chart I would simply extend the retracement above the previous peak of 1500 (giving a target of 2300) but long-term charts work better on a log scale.

If we extend the distance between peak and trough above the peak on a log scale chart, we get a target of 2800.

If we do the same for the global financial crisis (GFC), we get a target of 3200.

Mid-way between the two is another important target, of 3000, which is double the previous two peaks at 1500.

Of the three targets, I feel that 3000 is the strongest. Not only because it is the middle target and double the previous peaks, but round numbers are important psychological barriers. The Dow, for example, took more than 10 years to break resistance at 1000.

Now some may feel that technical analysis like this has as much significance as reading tea leaves or consulting your astrological charts. But observation shows that market activity tends to cluster around significant levels (e.g. 1500) or numbers and can present formidable barriers to trend progress.

Primary Support

The next question is: if the market reverses at 3000, how far is it likely to retrace? There is no straight answer, but primary reversals normally retrace between 50% and 100% of the previous gain, or between 25% and 50% of the current level.

There are two major support levels evident on the chart:

  1. The 2100 peak from 2015, a 50% retracement (on a log scale) of the preceding advance; and
  2. The 1500 peak from 2000 and from 2007, marking 100% retracement of the previous advance and also a 50% retracement from the current level.

A lot would depend on the severity of the reaction.

“You watch the market — that is, the course of prices as recorded by the tape with one object: to determine the direction. Prices, we know, will move either up or down according to the resistance they encounter. For purposes of easy explanation we will say that prices, like everything else, move along the line of least resistance. They will do whatever comes easiest, therefore they will go up if there is less resistance to an advance than to a decline; and vice versa.”

~ Jesse Livermore

Wesfarmers Ltd (WES)

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:

FY18 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.

Coles Demerger (November 2018)

Coles Group Limited (COL) commenced trading on the ASX on 21 November 2018, after the spin-off from Wesfarmers was approved by the Supreme Court of WA.

Trading is initially on a deferred settlement basis, with the demerger expected to be implemented on 28 November 2018.

  • Following the Demerger, Wesfarmers will continue to be one of Australia’s largest listed companies and private sector employers with around 105,000 employees.
  • Wesfarmers’ business operations will include Bunnings, Department Stores (K-mart & Target) and Officeworks retail divisions and the Industrials division with businesses in chemicals, energy and fertilisers, and industrial and safety products.
  • Wesfarmers will also have a number of other non-controlling interests, including a 15 per cent interest in Coles.
  • For the year ended 30 June 2018, Wesfarmers’ post Demerger pro forma revenue was $27.5 billion, pro forma EBIT from continuing operations was $2,734 million and pro forma EBIT from continuing operations and excluding significant items was $3,040 million.

Financial performance

Revenue Growth

Revenue growth stalled in FY18.

Revenue and EPS

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.

Net Income (adjusted) % of Revenue

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.

FY18 Return on Capital Employed by Segment

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.

FY18 Capital Employed by Segment

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.

Earnings per Share and Dividends

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.

Net Income & Free Cash Flow % of Revenue

Capital structure

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

Net Cash/(Debt) % of Equity

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.

Twiggs Momentum & Trend Index

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.

21-Day Trend Index

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

Gold rallies

Spot gold rallied late Friday, breaking the first line of resistance at $1600/ounce. Penetration of the declining trendline suggests that the down-trend is weakening, but 63-day Twiggs Momentum remains firmly below zero. Retracement that respects new support at $1600 would strengthen the bull signal, however, as would recovery of Momentum above zero.

Spot Gold

* Target calculation: 1500 – ( 1800 – 1500 ) = 1200

Spot gold tests $1530

The Dollar Index followed through after last week’s breakout above resistance at 81.50/82.00, confirming the fresh advance signaled by a 63-day Twiggs Momentum trough above zero. Target for the advance is 86.00*.

US Dollar Index

* Target calculation: 82 + ( 82 – 78 ) = 86

On the daily chart, spot gold tests medium-term support at $1530/ounce. Long tails indicate buying support but the rising dollar continues to apply downward pressure. Breach of support and follow-through below $1500 would signal a long-term decline to $1200/ounce*. Declining 63-day Twiggs Momentum (below zero) already indicates a primary down-trend. Recovery above $1600 is less likely but would indicate that the down-trend is weakening.

Spot Gold

* Target calculation: 1500 – ( 1800 – 1500 ) = 1200

Dollar strength continues

The Dollar Index is headed for a test of resistance at 80. The brief dip below zero on 63-day Twiggs Momentum suggests a solid primary up-trend. Breakout above 80 would offer a target of 85*.

US Dollar Index

* Target calculation: 80 + ( 80 – 75 ) = 85

China and Hong Kong

Hong Kong’s Hang Seng Index is testing medium-term support at 18000; breach would signal another test of 16000*. 13-Week Twiggs Money Flow below zero warns of rising selling pressure.

Hang Seng Index

* Target calculation: 16 – ( 20 − 16 ) = 12

The Shanghai Composite is testing medium-term support at 2400. Failure of primary support at 2300 would offer a medium-term target of 2000*. The long-term trend is edging lower in a controlled descent, so conventional target calculations do not apply. Recovery above 2600 is less likely, but would signal another test of the descending trendline.

Shanghai Composite Index

* Target calculation: 2300 – ( 2600 − 2300 ) = 2000

Brazil: Bovespa trend reversal

The Bovespa Index broke its descending trendline and resistance at 58000 to complete a classic Dow reversal. A higher trough on 13-week Twiggs Money Flow indicates long-term buying support. Consolidation below 60000 has formed a bullish ascending triangle; upward breakout is likely and would confirm a target of 70000.

Bovespa Index

* Target calculation: 60 + ( 60 – 50 ) = 70

DJ Europe warns of selling pressure

Dow Jones Europe Index is testing medium-term support at 230. Bearish divergence on 21-day Twiggs Money Flow warns of selling pressure. Failure of support would test the primary level at 210 — and breach of primary support would signal another decline, with a target of 160*.

Dow Jones Europe Index

* Target calculation: 210 – ( 260 – 210 ) = 160

Japan and South Korea

Dow Jones Japan Index is consolidating between 48 and 52. Breakout will signal future direction. 21-Day Twiggs Money Flow is rising but there is no clear break as yet above the zero line. Monday’s candle indicates continued hesitancy.

Dow Jones Japan Index


Dow Jones South Korea Index also showed hesitancy Monday. Reversal below 400 would warn of another test of primary support at 350, while respect of 400 would indicate a primary advance to 450*. 21-Day Twiggs Money Flow is declining but respect of the zero line would also signal a primary advance.

Dow Jones South Korea Index

* Target calculation: 400 + ( 400 – 350 ) = 450

Europe stumbles onwards

Markets have been fed a steady diet of press releases out of Europe for the past few weeks but very little substance. This is a dangerous strategy as hopes are raised and reaction to any form of disappointment will be strong. No matter how it is dressed up, we are likely to witness a substantial default of Southern European borrowers, requiring recapitalization of French and Northern European banks. With public debt close to danger levels in many of these countries, there are no ready funds available for a bailout. Quantitative easing by the ECB has been touted as a possible solution, but aversion to this is so strong — particularly in Germany — that it would be political suicide for Angela Merkel to support this. So Europe stumbles onwards, searching for a disguised form of QE solution that is palatable to German voters.

Germany’s DAX is testing support at 5600. Breach would test 5000, while respect would signal a primary advance to 7200*. 13-week Twiggs Money Flow is relatively weak and reversal below zero would warn of renewed selling pressure.

DAX Index

* Target calculation: 6400 + ( 6400 – 5600 ) = 7200 OR 5700 + ( 5700 – 5000 ) = 6400

France’s CAC-40 index is testing medium-term support at 3000. Failure would test 2700, while respect (signaled by breakout above 3350) would signal a further advance. 13-week Twiggs Money Flow remains weak and reversal below zero would also warn of renewed selling pressure.

CAC-40 Index

* Target calculation: 2700 – ( 3300 – 2700 ) = 2100

Italy’s FTSE MIB index is similarly testing support at 15000. Again, 13-week Twiggs Money Flow is weak and reversal below zero would warn of renewed selling pressure.

FTSE Italian MIB Index

* Target calculation: 13 – ( 17 – 13 ) = 9

The FTSE 100 index is testing support at 5350. Failure would test primary support at 4800, while respect (signaled by breakout above 5700) would confirm a primary advance to 6100*. Rising 13-week Twiggs Money Flow favors an advance.

FTSE 100 Index

* Target calculation: 5400 + ( 5400 – 4800 ) = 6000