With retail revving, Wesfarmers' road opens up

Wesfarmers retail brands are starting to deliver returns on equity in the vicinity of what the conglomerate was boasting before those massive acquisitions. The timing is a validation of diversification.

Over the past five years, whenever Richard Goyder has presented Wesfarmers’ results he’s been aggressively questioned about the impact of the 2007 acquisition of Coles and its sibling brands on his group’s once-remarkable returns on equity. That’s steadily becoming a non-issue.

Coles’ bumper result – leveraging a 4.8 per cent increase in sales into a 15.1 per cent leap in earnings before interest and tax, to $755 million – has put the food and liquor business within sight of a double-digit return on capital.

Four years ago Coles’ return on capital was a meagre 5.1 per cent (which is somewhat misleading given that accounting rules forced Wesfarmers to value its investment on the basis of shares issued at the peak of a pre-crisis bull market).

In the latest half-year, however, Ian McLeod and his team has maintained their remarkable run of strongly improving results and boosted Coles’ return on capital (on a rolling 12-month basis) by a full percentage point, to 9.2 per cent. If they can maintain the momentum, by the end of the financial year it could be nudging double digits.

The basket case of the group of retail brands Wesfarmers acquired, Kmart, had a return on capital (adjusted for a subsequent reallocation of capital that added $488 million to the denominator) of about 7 per cent four years ago and annual earnings of only $109 million on a $4 billion revenue base. It was a brand without an identity or strategy and virtually without earnings.

In the latest half, on sales of $2.3 billion, Kmart earned $317 million and generated a return of 22.5 per cent on capital. Its earnings before interest and tax grew 15.9 per cent in the half in a continuing demonstration of the success of the relentless and disruptive Guy Russo strategy of continually lowering prices on a far more focused range of everyday items. He and his team are up to 12 consecutive quarters of growth in the volume of transaction and items sold.

The other major brand Wesfarmers acquired was Target. Even within the old Coles Myer Target had been a stellar performer and it remained so in the first years within Wesfarmers' fold. About a year and a half ago, however, it started sliding and Wesfarmers was forced to pay more attention to it, replacing Launa Inman as managing director with Dene Rogers and initiating a major restructuring of the business. It is conceivable that Target has been caught in the backwash of Kmart’s impact on discount department store retailing, which has coincided anyway with what are very difficult conditions at that end of the market.

Target’s numbers aren’t anywhere as pretty as its siblings. With sales flat-lining, its earnings were down 20.4 per cent to $148 million and its return on capital slid further, from 8.9 per cent to 7.1 per cent. Its first published return on capital within Wesfarmers was 10.4 per cent.

Both Goyder and Rogers, however, say there has been an encouraging improvement and some momentum in Target’s trading performance – and they appear confident it is back on track to generate stronger performance.

The latest result included some undisclosed but "significant" costs and investments in the change strategy (Goyder indicated they were in the "tens of millions" of dollars), so presumably its underlying operational performance was somewhat better than the raw numbers presented.

Wesfarmers’ pre-existing retail business, Bunnings, lifted its earnings before interest and tax 6.8 per cent to $875 million and, while its return on capital edged down from 27 per cent to 25.5 per cent, it remains a fabulous business.

Bunnings’ growth in earnings and its returns have been flattened in recent times by an aggressive and capital-intensive expansion of its store network by John Gillam in, initially, anticipation and then response to the entry of Woolworths to the hardware sector with its Masters joint venture with Lowe's of the US. Bunnings opened 15 new stores in the half and has a development pipeline of more than 90 new sites.

With some of that property and the capital in it being recycled and the property shifted off Bunnings’ balance sheet, its returns should begin rising again.

Goyder is a strong advocate of the strength in diversity generated by Wesfarmers’ unfashionable conglomerate structure.

The 63 per cent decline in earnings from Wesfarmers’ resources division – from $250 million to $93 million – as a result of the sharp falls in export coal prices and the strength of the Australian dollar during the half would have been traumatic for a less diversified group.

As it was, the performance of its retail brands and a significant recovery in its insurance arm enabled the group to produce a 9.3 per cent lift in after-tax earnings. Goyder expects further growth in earnings from the retail businesses in the second half.

Wesfarmers is also starting to build its free cash flows, which rose about 30 per cent in the half, as its program of selling and leasing back retail properties starts to accelerate. Its net capital expenditure in the half was $1.12 billion, about 11 per cent less than the same period previously.

While the group will continue to invest to expand and renew the Coles food and liquor store networks, and continue Bunnings’ expansion, in net terms its capital expenditure program appears to have peaked.

Wesfarmers will, in the not-too-distant future, be able to consider whether it invests its free cash in capital management to further improve its returns and reward shareholders or opts for an acquisition strategy that has been on hold for five years as it digested the retail brands acquired in 2007.