All change at Wesfarmers

The media isn’t focusing on Wesfarmers’ management transition, but it’s more important than the slow creep of negative news.

Here’s the thing. You won’t get a chance to buy Wesfarmers without a spot of bad news. With the retail sector – responsible for more than 80% of the company’s earnings – on the nose, the negatives are intensifying. Some might say that managing director Richard Goyder has timed his exit judiciously.

In fact, recent management changes are important to the long-term future of Wesfarmers, more so than shopping swings and retail roundabouts. Before getting to this changing of the guard – and what it means for Wesfarmers’ future – what did last week’s Strategy Day reveal?

Well, the first item of bad news was that Coles continues to reduce prices and boost service levels. Great for customers, less so for shareholders. An unusually subdued Coles managing director John Durkan flagged an almost $200m investment this half, implying another deterioration in profitability.

Key Points

  • Coles 2017 earnings to fall

  • Bunnings and Kmart sales to slow

  • Significant management change this year

After the underlying 8% decline in Coles’ first half earnings, the full-year number is likely to be down more than 10% – the first annual fall in earnings since Wesfarmers acquired it in 2007. With Woolworths getting its mojo back, Durkan referred to 2017 as an ‘unprecedented year’ at the Strategy Day. Cost savings should offset some of Coles’ pain but they’ll take time to come through.

There’s your toot

In Wesfarmers: Interim result 2017 in February we said that it’s ‘too early to say much on Bunnings UK’. That remains the case, although it’s apparently off to a weaker start than management hoped. Homebase is labouring under an uncompetitive kitchen and bathroom offer, and management is apparently having trouble migrating the Bunnings Australia shop floor staff culture to the UK. Losses will continue into the first half of 2018.

Bunnings Australia and New Zealand is performing well, as usual, but beware high expectations. The 8%-plus same-store sales growth reported between 2014 and 2016 will certainly moderate as the housing boom does. The 3–4% reported during the 2011 to 2013 period is probably a more realistic estimate of future sales growth but we’re not sure the market has cottoned on yet.

In the department store division, Kmart continues to be the star and Target the laggard. Kmart’s management repeated that margins are at peak levels, although it has an aspirational goal to double sales. That seems optimistic, with same-store sales growth already slowing from last year’s 10.5%.

Fashion victim

Target’s sales have collapsed over the past year and it will be a slow turnaround. But if anyone can resuscitate this ailing patient it’s Guy Russo, the architect of Kmart’s turnaround. The reorientation of the brand to differentiate it from Kmart makes sense, although ‘quality fashion’ is a crowded segment and harder to defend. Our view is that Target can once again be sustainably profitable, although Kmart’s 10% operating margin looks vulnerable given the threat of Amazon.

While we’re on the subject, Wesfarmers’ retail businesses might be affected by Amazon’s Australian entry, although to varying degrees. Why worrywart consumers are a bigger threat to retailers than Amazon outlined our initial view but look out for a comprehensive analysis of how Amazon might affect ASX-listed retailers – including Wesfarmers – shortly. Amazon is already causing havoc, with its arrival playing a role in Wesfarmers’ recent decision to cancel the sale of Officeworks.

Table 1: Wesfarmers valuation
  2016 Low
multiple
High multiple Low value High
value
  EBIT ($m) x x ($m) ($m)
Coles 1,860 9 14 16,740 26,040
Bunnings ANZ 1,213 12 17 14,556 20,621
Bunnings UKI       0 0
Officeworks 134 8 12 1,072 1,608
Target (50)     600 1,400
Kmart 470 7 10 3,290 4,700
Resources (310)     1,500 3,000
WesCEF 326 6 9 1,956 2,934
Industrial & Safety 98 10 14 980 1,372
Less Corp./Other (124)     (1,000) (1,000)
Enterprise value       39,694 60,675
Less Net debt       (4,700) (4,700)
Equity value       34,994 55,975
Value per share ($)       30.86 49.37

With Wesfarmers’ share price caught up in the sector-wide turmoil, we’ve once again reviewed our Wesfarmers sum-of-the-parts valuation (see Table 1). While some divisions are higher and some lower since Wesfarmers counts on Chaney (from December 2015), our overall valuation has risen slightly.

Sentiment ebbs and flows, of course, but rising profitability should drive an increasing valuation over time – and that’s exactly what has happened. We see little reason to lower our Buy price despite the negative news intensifying. We remain ready to upgrade around $38.00.

Pivotal appointment

In the end, it will be how management allocates capital that determines the future success of an investment in Wesfarmers. With significant management change underway, it’s something worth reflecting on. Just as Richard Goyder’s acquisition of Coles Group in 2007 reshaped Wesfarmers, so might Rob Scott’s appointment be just as pivotal.

Thankfully Scott, who will become managing director in November, appears schooled in the ‘Wesfarmers way’. At the Strategy Day he said all the right things and we’re less worried by this transition than we would be at most companies. The fact that former Wesfarmers managing director Michael Chaney is chairman of the board also provides significant comfort.

You should be ready for Wesfarmers to make big acquisitions under Scott’s management. While he’ll probably be less gung-ho than Goyder – Coles Group was 30% bigger than Wesfarmers when Goyder made his move – it’s clear Wesfarmers now regards portfolio businesses like Officeworks as too small. Scott is currently head of the Industrials division and we think that’s where acquisitions are most likely – think mining, chemicals, agriculture, or energy.

It’s not just Goyder who’s moving on. Bunnings’ head John Gillam left in December with Michael Schneider replacing him. Gillam left big shoes to fill and, based on his Strategy Day presentation, Schneider isn’t filling them just yet. Terry Bowen, Wesfarmers’ very well-respected chief financial officer, is also stepping down this year.

So Wesfarmers will have a new managing director, chief financial officer and divisional head of Bunnings in one year. It a great deal of management change, which should always give shareholders pause for thought.

Of course, one of Wesfarmers’ great strengths is its culture and history of careful management transitions. We’ve no reason to believe it will be different this time.

But with historically strong sales and earnings growth from Coles, Bunnings and Kmart easing, there will be pressure on management to identify a new source of growth. While acquisitions always add a layer of risk, the company’s focus on returns rather than empire-building is reassuring. Wesfarmers has form.

Recent worries about the retailing sector don't change our view that Wesfarmers is one of Australia’s 10 best businesses. We’re getting ever-closer to an upgrade but, for now, we recommend that you HOLD.

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