Wesfarmers: Interim result 2017

Between them, Coles and Bunnings still generated two-thirds of Wesfarmers' earnings in the first half of 2017. But for the first time in a long while profits from the two giants moved in opposite directions – and arch-rival Woolworths – was largely to blame.

Coles' operating profit declined 3% but, excluding property transactions, the underlying fall was closer to 8%. Management attributed this to the impact of increased competition on gross margins. With Woolworths investing around $1bn into lower prices over the past year and Aldi expanding into South Australia and Western Australia, the remainder of 2017 will be tough.

Down, down

While the Coles result was weaker than expected, Bunnings Australia reported another surprisingly strong result, with profit up 10%. As JB Hi-Fi has taken advantage of the collapse of Dick Smith, so Bunnings has capitalised on Masters' exit. The Bunnings result was even better than it looked because the company absorbed $30m in costs to close 11 stores as it prepares to move into 15 former Masters sites.

It's still too early to say much on Bunnings UK. The business reported a sizeable loss of $48m in the seasonally weaker first half but the first Bunnings pilot store is now open. Management has reported ‘pleasing' customer feedback but there's a long way to go.

In Department Stores it was another tale of two retailers. Kmart was the star once again, with earnings rising 16% although management warned it was approaching peak margins (something we've also warned about). Target's sales plunged 18% but management vigorously attacked the cost base, allowing the business to remain profitable (just). The turnaround will take time, but there's clearly a lot going on behind the scenes and we're confident Target's earnings can grow from here.

Officeworks has been one of Wesfarmers' success stories, having doubled its profit since acquisition. First-half earnings growth was a subdued 5% but it remains a very strong business. So it was somewhat surprising to hear Wesfarmers has put it up for sale, perhaps by initial public offering.

As with all assets Wesfarmers won't sell unless it gets the right price, and our view is that the $1.0-$1.3bn valuation the market has applied is way too low (our ‘high' value from Wesfarmers counts on Chaney is around $1.9bn).

You'll remember too (from Wesfarmers' coal curveball last month) that the Resources division is also up for sale. Here too we suspect Wesfarmers expects more from the assets than the market does.

With the Resources result having been flagged last month, it was in line with expectations. Higher coal prices generated a $256m turnaround in earnings although forecasting the second half is nigh on impossible.While revenues were lower for the two remaining Industrials businesses, Chemicals, Energy and Fertilisers (down 8%), and Industrial and Safety (down 5%), the earnings performance was a lot better. Each reported significant lifts in earnings thanks to higher ammonium nitrate sales at the former and benefits from the recent restructuring at the latter.

Seamless transition

We'd been expecting Richard Goyder to step down as managing director and he announced his retirement earlier this week. Industrials boss Rob Scott will take over as managing director following this year's annual general meeting. The change is very much the ‘Wesfarmers way', with a long lead time and a youthful internal appointment.

Also notable is that Wesfarmers is apparently ‘slimming down' in preparation for the management transition. It recently sold the Coles credit card book for around $900m. Add to that another $4–5bn that might be raised from selling the Resources division and Officeworks and company's $5.4bn of net debt might be almost eliminated.

Why that might be we'll discuss at a later date, but it's likely that Wesfarmers' is entering a more difficult period. We also wonder whether the board is ‘clearing the slate' to allow for another big acquisition down the track. Our view is that the board didn't select Rob Scott, with his ‘mergers and acquisitions' experience, for nothing.

Altogether, Wesfarmers' overall result looked somewhat better than it was. Most of the 13% increase in net profit came from a coal price-driven turnaround of the Resources business. Management will be fighting numerous battles over the next year as it tries to defend early market share losses to Woolworths, and advances the turnarounds at Target and Bunnings UK. We're still confident of an opportunity to buy around $38 a share at some point and remain very happy to HOLD.