Wesfarmers: Not as good as it seems

PORTFOLIO POINT: Coles is key to improving Wesfarmers’ return on equity, and the retailer will need to increase earnings enormously to bolster its parent’s ROE.

This week I am writing my column for you with neither pen and paper nor keyboard. New technology allows me to simply speak the words and they magically appear on the screen. While dictation software is nothing new, this version is supposed to understand business words and phrases. Despite its specific design however, it still misinterprets a few words. The word ‘diluted’, for example, does not appear as it should and while it’s frustrating, it is also quite illuminating, as you will see later.

I opened the papers this week to discover Richard Goyder from Wesfarmers had admitted the capital raising five years ago, to ostensibly purchase Coles, had ‘diluted’ (there’s that word again) return on equity by three quarters. Perhaps unwittingly however, he had also contradicted the company's chairman.

Back in May this year Wesfarmers’ chairman Dr Bob Every was quoted as saying: “The main way we create value to shareholders is to increase return on capital. There’s no doubt when we bought Coles we bought a very big business with very low return on equity and that reduced the return on equity for the company,”

Shortly afterwards I made the point that such a conclusion was difficult to reach from the observable facts.

In 2007, Coles generated $747 million in profits off an average equity base of $3.75 billion. This is equivalent to 19.9%, which could hardly be described as very low. ‘Very low return on equity’ is what Wesfarmers is generating now.

The basic reason for Wesfarmers’ low rate of return on equity is that it simply paid too much for Coles.

If you wanted to purchase a business that spat out $747 million in earnings each year, and you wanted a 10% return on your money, you could pay $7.5 billion, which would be roughly two times the equity. If you wanted a 6% return you could pay $12.5 billion or roughly three times the equity. Who knows what return you are after if you pay $22 billion for Coles or nearly six times the equity? And that is approximately what Wesfarmers paid!

Years later they are still grappling with the issue of low rates of return on equity.

Sure, as Mr Goyder notes, the share price has gone up, so on a total return basis the acquisition has been a good one for shareholders but, as Warren Buffett profoundly noted when misquoting Ben Graham: “in the short run the market is a voting machine” – a popularity contest – “but in the long run it is a weighing machine”. In the long run, the market will price shares to reflect the economic performance of the underlying business and if return on equity does not increase, the share price will fall to the intrinsic value of the company, which based on the low return on equity is much lower than the current share price.

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We already know that when you raise capital to pay debt, the return on the equity that you’ve raised is merely the interest rate on the debt you have paid off. If, as an organisation, you are already generating a much higher rate of return on equity than debt interest, that return on equity will be ‘diluted’ (there it is again) whenever you raise equity to pay debt.

To get returns on equity back up, Coles’ EBIT will have to rise enormously, and perhaps even double, before an acceptable rate of return on equity, or a rate that justifies the current price, is achieved. If that doesn’t transpire, the only thing that is holding the share price up is the many institutions who take a minimising-tracking-error approach to stock selection and portfolio construction. And that never lasts.

In 2007 Wesfarmers was proud of its return on equity target for measuring not only business performance but also executive remuneration.

When Richard Goyder began at Wesfarmers his base salary was $2.3 million. According to board statements at the time, Mr Goyder’s salary “contains no short-term incentive component, as the board is of the view that the chief executive should be judged, and rewarded, based on performance over an extended period”. His long-term incentive was based on achieving an “increase in shareholder wealth over the term of his appointment”. The board set a challenge for Mr Goyder – a hurdle that Wesfarmers achieve and sustain a challenging targeted return on equity of what was widely reported to be 12.5%.

Sadly, the material drop in return on equity (following the capital raising, debt repayment, tough retail conditions, low ROE of Coles or insert your own excuse) meant that the long-term targets set for Mr Goyder would be difficult to meet (and underlings will be paid much more).

But in a 2008 example of altruism and deference to the shareholder-owners it is charged to represent, the board changed the terms of his remuneration permitting Goyder to receive a short-term incentive. And in 2011 the long-term incentive return-on-equity target was also changed so that the company merely needed to generate growth in return on equity that exceeded the average of companies in the ASX/S&P50 index. The ASX/S&P50 index includes Qantas, Leightons and Telstra. Not a tough hurdle to beat and arguably irrelevant.

Not surprisingly, last year Mr Goyder received $8.01 million including $1.148 million of long-term cash and share incentives, up from $6.935 million in the previous year.

It seems it is not only the incentives that have changed, but also the culture. Years ago Michael Chaney noted that his $2 million salary had “risen to levels beyond those originally envisaged for excellent performance” and voluntarily capped it.

Oh and that dictation software glitch? It turns the word ‘diluted’ into ‘I looted’.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.