Autonomous teams deliver for Wesfarmers

The ability of Wesfarmers' retail brands to continue their resurgence within a hostile environment for retailers says something about the quality of their managements and the Wesfarmers approach to managing them. It probably also says something about the way they used to be managed.

Coles lifted sales 6.4 per cent, significantly out-stripping its arch rival Woolworths, and generating a 16.3 per cent increase in earnings before interest and tax to maintain the momentum it has displayed since Ian McLeod and his team got their feet under their desks.

Kmart, written off as a basket case when Wesfarmers acquired the portfolio of brands in 2007 – and almost shut down – increased its revenue by only 0.5 per cent but produced a 32.3 per cent increase in EBIT and, despite a reallocation of $488 million of capital from Target to Kmart earlier this year, generated an 18.7 per cent return on capital.

Target, in the midst of a major restructuring, saw sales drop 1.2 per cent and earnings 12.9 per cent, but earnings would have been marginally up had it not been for a $40 million provision for the restructuring costs.

Both Kmart and Target are at the end of the market where competition has been most torrid and where their rivals have been ravaged by deep discounting, anxious consumers and the emergence of online retailers.

Against that backdrop, Kmart, pursuing its distinctive and disruptive strategy of a radically reduced range and very deeply discounted pricing, is performing brilliantly and Target has done well to stabilise its earnings.

It is apparent, and has been for some time, that the management teams Wesfarmers appointed are talented and creative and have been quicker on their feet than their peers. Their performance post-acquisition would also suggest that the former managements of those businesses don't fare well by comparison.

It would also appear safe to conclude, five years after the brands became part of the Wesfarmers conglomerate structure, that the Wesfarmers' model – which gives its businesses considerable operational independence but strict financial accountability – has demonstrated its effectiveness and value.

It hasn't tried to manage the retail brands as a portfolio – the Kmart strategy has, for instance, almost certainly adversely affected Target – but as individual businesses. Where Coles Myer once tried to avoid internecine warfare and cannibalisation, the Wesfarmers' approach is self-evidently more effective.

The extent of the resurgence in the brands probably also says something about the state of the businesses at the point of acquisition.

Coles, for instance, has added about 360 basis points to its return on capital and 120 basis points to its margins since 2007 despite massive and continuing investment ($1.2 billion in the year to June). With only a third of its stores converted to its new format there is still a lot of upside, which points to how rundown the Coles store network was when Wesfarmers' acquired it.

The recent performance of Kmart since it adopted its new model has been nothing short of miraculous – Kmart had been a brand perennially, and fruitlessly, in search of a model and a market position until Guy Russo and his team developed their strategy.

The ability of the Kmart team to experiment with a radical model that is unique within this market and very rare elsewhere illustrates the "loose/tight" approach Wesfarmers takes towards its businesses, where it gives its management the ability to manage so long as they meet very stringent financial criteria.

The "other" retail brand in the Wesfarmers portfolio, Bunnings produced a solid rather than spectacular performance, with sales up 5.6 per cent and EBIT 4.9 per cent. With margins of nearly 12 cents in the dollar and a return on capital of about 26 per cent it is a very high-quality business which is investing heavily to shore up its dominant position in the industry as Woolworths ramps up the rollout of its Masters chain.

It wasn't just the retail brands that shone within the Wesfarmers group result. An overall increase in earnings of 10.6 per cent to $2.13 billion is an excellent achievement in a difficult environment but one that would have been even better had its insurance division's earnings not been hit by the Christchurch earthquake. Wesfarmers increased its reserve estimate for the earthquake's impact by $108 million during the year.

If that and the Target provisioning were excluded, along with $42 million of insurance proceeds within the chemicals, energy and fertiliser prior-year earnings, the underlying earnings in all of Wesfarmers' divisions improved.

With cash pouring through the group – operating cashflows of $3.64 billion and free cashflows of $1.5 billion – and a conservative A-rated balance sheet, the group not only has the capacity to support a very heavy, $2.6 billion-plus capital expenditure program but with the retail brands now performing solidly despite the difficult environment could, if it wished, restart its traditional expansion by acquisition or embark on some significant capital management programs.