Wesfarmers defies retail gravity

While Coles continued its impressive earnings growth in the first half amid exceptionally tough conditions, the standout performer in the Wesfarmers stable was Kmart.

Last financial year, Wesfarmers’ Coles supermarket and liquor business grew its earnings at more than three times its rate of sales growth. For the first half of this year earnings grew at ‘only’ twice the rate of the increase in sales. Is the momentum of Coles’ resurgence maturing and slowing?

Probably not. In fact the 14.1 per cent increase in Coles’ earnings before interest and tax and, indeed, the 12.6 per cent increase in EBIT generated by its discount department store sibling Kmart on sales that actually shrunk 1.5 per cent, were very impressive performances in a retail environment that has been exceptionally tough.

For Coles to generate such strong sales and earnings growth in the context of relatively weak demand and price deflation estimated at 2.4 per cent is a considerable achievement – one magnified by the struggles its once-dominant competitor, Woolworths, is having generating meaningful growth in sales and earnings.

The performance of the supermarkets division was even better than it might appear at face value because its liquor business, in the midst of some significant restructuring and an IT transition, didn’t perform as well as the food side of the business.

Coles, since Ian McLeod and his team got their feet under their desks, has consistently grown sales, earnings, margins and its return on capital, which is now up to 8.2 per cent and edging towards respectability.

When Wesfarmers acquired Coles its return on capital was 5.1 per cent.

That is itself a considerable achievement given, as discussed previously, the team inherited a notional capital base inflated by the fact that Wesfarmers bought the business (and the other Coles retail brands) largely with pre-crisis inflated scrip.

The Coles team has been remarkably successful in generating foot traffic and transaction growth in their stores, as well as repositioning the brand through the irritating but effective ‘Down, Down’ campaign and driving down costs within its supply chain.

The rate of investment in new stores and Coles’ new format is also gathering pace, with $625 million invested in the division in the latest half against the $334 million of capital expenditures in the same half of the previous year.

While the Coles results are inevitably the focus in analysis of the performance of Wesfarmers’ retail brands, the Kmart results are extraordinary.

Department stores, even discount department stores, are supposed to have been – and most have been – smashed by the price and margin deflation created by cautious consumers, the strong dollar, the rise of internet shopping and their own intensely competitive responses.

No one has been more intensely competitive in this environment than Kmart’s Guy Russo, who is being blamed by his competitors and suppliers for exacerbating the damage being inflicted with his strategy of radically reducing the Kmart range and then deeply discounting it to drive volume.

To generate earnings growth of 10.9 per cent in the current environment, on sales which slipped 1.5 per cent, is like defying gravity.

Despite a reallocation of $486 million from Target to Kmart (to correct what Wesfarmers said was an error) Kmart is generating a 15.5 per cent return on capital.

Kmart was the brand that Wesfarmers almost discarded and probably only retained to keep its properties out of Woolworths’ hands. Even pre-Wesfarmers it was a brand that had lost its way, with no defining strategy or image. Today’s simple and clear proposition appears to be cutting through with consumers and disrupting competitor brands.

Among them is Target, whose earnings fell 9.7 per cent. Target is particularly exposed to the worst of the retail recession because of its large apparel offering. In its results commentary, however, there was a slightly more optimistic tone.

The other big retail brand, Bunnings, produced a solid result, with earnings up 6.1 per cent on a 6.3 per cent increase in sales.

As it prepares for the steady ratcheting up of the presence of the new Woolworths-sponsored competitor, Masters, Bunnings has been investing heavily in refining its offering and expanding and upgrading its store network – and investing in price reductions to protect its franchise and customer base. It was still able to maintain its EBIT margin which, at 12.7 per cent, signals how profitable and well-managed the chain is.

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