Retail wars: Wesfarmers readies for battle

During the week Wesfarmers’ market capitalisation passed $40 billion. The stock, at around $39.50, is now priced at about 20 times its expected earnings for 2012-13 of around the $1.95-$2 a share mark.

When you look at Woolworths, which is the market leader in supermarkets, the stock is priced at about $34, which is about 17.5 times expected 2012-13 earnings of around $1.92. And, if the forecasts are right, Woolworths will grow profits to take that price earnings ratio below 15 in three years.

The market clearly is rating Wesfarmers as worthy of further growth by giving it a price earnings ratio higher than the supermarket leader. On the other hand, Wesfarmers pays out 90% of its profit in dividends (and plans to continue that rate) so that enabled the company to pay a fully-franked dividend of $1.65 per share in 2011-12 and an estimated dividend of about $1.77 cents per share in 2012-13, which provides a yield of 4.5% fully franked.

This is certainly better than bank deposits, so it is worth looking at just what the prospects are for Wesfarmers. In many ways Wesfarmers has a similarity with Telstra in that it spins off vast amounts of cash, and that enables it to pay high dividends.

About 22% of the group’s earnings before interest and tax in the 12 months ended December 31 (balance date is actually June 30, but the company each half year makes up a theoretical yearly calculation to December 31) came from non-retail activities, led by insurance, coal, fertilisers and energy. Clearly earnings from these areas are being rated as though they are from a retailer, and that is a weakness in the group’s earnings make-up.

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Going deeper into the retail operation, just over half the total Wesfarmers group profit (EBIT) comes from the mighty Coles business, which is one of the most spectacular turnarounds in Australian corporate history. The first question we must ask is, is the Coles growth journey over or has the Coles restoration not yet finished? And the answer from Wesfarmers is a resounding “no”. In fact, it is probably just a little over half way.

Woolworths took an enormous lead over Coles a decade ago when it invested heavily in its supply chain and in the appearance and layout of its stores. Woolworths also invested heavily in liquor and poker machines. It has also added new stores at a fast rate.

Coles and its previous owners sat on their laurels and made no similar extensive investment – particularly in the supply chain. Coles do not plan to match Woolworths in poker machines but it is revamping its liquor business and beginning to step up the opening of new stores. Accordingly, Wesfarmers is now proceeding full bore on the Woolworths catch-up, but it will take probably three, four or even five years to make the Woolworths grade in the supply chain and liquor.

At the same time Coles has only refurbished into its new format about one-third of its total number of stores, so there is a lot of work to do over the next three or four years. And you can see the difference between Coles and Woolworths when you look at the returns each company achieves on its sales. Woolworths has an amazing 7.5% margin, whereas the Coles margin is only around 4.5%.

Coles believes (and Woolworths denies it) that Woolworths charge higher prices, and this contributes to the higher margin. But leaving that argument aside, the main cause of the margin difference is the far better supply chain that Woolworths has organised and the greater investment Woolworths has made in store refurbishment, liquor and poker machines.

But Coles believes that it can catch up, although it does not believe that Woolworths’ 7.5% margin is sustainable. So in the next five years we are going to see an increase in Coles’ margins as its supply chain is improved, liquor revamped and expanded, and its stores refurbished.

But it also plans to accelerate its price reductions to put more pressure on Woolworths’ market leadership. Given the amount of margin difference between Coles and Woolworths, there is clearly room for profit growth at Coles. If I was running Woolworths I would feel a little nervous, because the sleeping giant has woken up and plans to put increased pressure on the number one player.

But Woolworths believes that its greater knowledge of its customer purchasing patterns and its enormous customer base will enable Woolworths to better target promotions. It no longer needs to pursue customer acquisition.

Coles will also be tailoring its promotions to its customer base, but clearly believes it can take customers from Woolworths and others by further reductions in prices, which Woolworths will not be able to match without reducing margins. That’s the war ahead, and the market is in love with the Wesfarmers’ story.

At the moment there is an Australian Competition & Consumer Commission inquiry planned into the supermarket business. I could be wrong, but I think it will be a little like the service station inquiries that really didn’t get anywhere. No doubt there will be instances where both Woolworths and Coles have been too tough on suppliers, and it will get corrected. But any major change would clearly put the price of food higher, along with the Australian inflation rate. That is not exactly what the ACCC is designed to do. So clearly there is growth still available to the Coles’ company.

In Wesfarmers’ second-largest retail business, Bunnings, the company is planning an avalanche of new stores as it stamps its leadership on that home improvement sector of the market.

It is not going to let Woolworths’ Masters Home Improvement group get anywhere near Bunnings’ market size. So Woolworths will be second or third fiddle in the market – which is not where the company is used to being. However, the early returns from Masters are better than expected, so there may be room for both. But there is also a change coming in the Bunnings’ business that will affect Wesfarmers’ shareholders. The company has been developing a lot of new stores and those stores are now reaching the point where Wesfarmers can sell the freeholds to investment groups and lease them back. That will release a lot of cash for Wesfarmers. And, for the first time since the purchase of Coles back in 2007, Wesfarmers is now looking around and thinking about what it should do with the looming increased flow of cash.

Wesfarmers vs Woolworths

Data as at February 21, 2013

Shareholders will, of course, be pressing for capital returns, buy-backs and higher dividends, and that may take place. But the group is also looking at expanding its coal business (coal mines are going very cheaply) and other areas in which it operates. Now I emphasise that Wesfarmers is just looking, and in the case of coal I hope (and expect) it will continue to just look. There is no certainty that it will make a non-retail expansion. It is also, of course, looking at expanding the retail area. And similarly, in retail there is no certainty that it will make an acquisition. What is important is that Wesfarmers is becoming a cash powerhouse again, and it can make acquisitions if that is what it wants to do. Returns on acquisitions will be matched against giving spare capital back to shareholders.

In former times, when Wesfarmers debt was $5 billion-plus, it was linked to a much smaller Wesfarmers’ market capitalisation and the group looked highly geared. But with its market capitalisation at $40 billion, $5 billion in debt looks incredibly small, although there are extensive lease backs. So the cash that is being spilled off could be leveraged to enable a larger acquisition to be undertaken.

In Australia today shareholders want income, but Wesfarmers’ management also has an eye for further growth. But given the looming cash flow, that should not affect the high payout ratio. There will be a lot of debate on this subject in the next couple of years.

Currently what impresses many brokers is the Wesfarmers group’s containment of costs. Costs rose less than 1% in the December half year. I suspect that small rate of increase is not sustainable longer term, but the high dividend policy will continue and capital returns are back on the agenda. Wesfarmers is no longer a cheap stock, but it has become an important part of a great many portfolios and is well worth holding for the longer term.

If I was Richard Goyder I would think seriously about selling coal. His response to that is the coal market is very low, so it is very difficult to sell coal. In any event he believes that in the longer term Wesfarmers will do well in metallurgical coal. Thermal coal will be tougher, but Wesfarmers is a low-cost producer and that should guarantee longer-term returns. In other words, he has no plan to sell the coal business unless a very attractive offer comes in.

I don’t think there us any need to rush out and buy Wesfarmers’ shares because the market is well and truly recognising the company’s potential, but the stock is an important pillar in any long-term diversified portfolio.