Wesfarmers: Interim result 2019

'Show me the money', said Wesfarmers shareholders - and the company duly obliged. Fresh from selling non-core assets and demerging Coles Group, Wesfarmers ended the half-year to December with net debt of just $300m.

With free cash flow of $2.4bn pouring out of the company in the half, Wesfarmers was awash with cash. As a result shareholders will be paid a special dividend of $1.00 per share in April, on top of a $1.00 per share interim.

Don't assume that the special dividend means an acquisition is off the agenda. Managing director Rob Scott made clear on yesterday's conference call that the company is looking high and low. There could be 'bolt-ons', even in retail or technology, Scott said, but sizeable targets would sit within its 'Industrials' division. (Our tip: fertiliser and explosives company Incitec Pivot should watch its back, although the ACCC could be a spoilsport.)

Most divisions generally performed well in the half. Bunnings was again the stalwart although, with more than 370 stores in Australia and New Zealand, this is looking increasingly like a mature asset. The days of double-digit profit growth are probably behind it, however much management talks up its potential.

Divisional results suggested as much. Bunnings sales rose 5% to $6.9bn, with same-store sales growth of 4.0%. While operating earnings grew 8% to $932m, property profits were higher than average; excluding those, growth was more like 6%.

As usual Bunnings management was reluctant to say anything about how the housing market might affect sales, but it did note that trading conditions were 'moderating'. Subdued retail conditions seem to be a recurring theme of this reporting season.

Hitting the Target

In Department Stores, which management has confusingly renamed 'Kmart Group', revenues were flat at $4.6bn while underlying operating earnings fell 4% to $383m. For once Target wasn't the main problem, with management calling out 'earnings growth' at the brand. Hooray for that, although Target is effectively shrinking - eight stores were closed in the half.

After an extended period of stellar results, the Kmart brand stalled during the period. Same-store sales fell slightly and earnings fell by more - we estimate about 10% (management no longer reports Kmart and Target earnings separately). The main problem seems to be that Kmart stuffed up its womenswear offer in the half. That's retail for you: merchandising mistakes happen.

Officeworks might be the smallest retailer in Wesfarmers' portfolio but it could lay claim to being the mightiest this half. There's no sign of Amazon encroaching on Officeworks' territory, with revenues rising 8% to $1.1bn and operating earnings up 12% to $76m. The high returns and growth from this business have been a feature of Wesfarmers' ownership, although it's presumably still for sale at the right price.

Coal begone

With Wesfarmers having cast off the last of its resources businesses, the Industrials division has slimmed down. It's still a grab bag of assets, though, and some of them have been underperformers for a while.

Take the Industrial and Safety business. Revenues were flat at $876m while earnings fell 19% to $42m. The Blackwoods distribution arm is still progressing through a prolonged turnaround, while the Workwear business acquired under former management has always looked like a dud.

Also within Industrials sits the Chemicals, Energy and Fertilisers business. Diversity is the strong point here, as earnings can be buffeted by seasonal factors, commodity prices, exchange rates and plant outages.

Ammonium nitrate demand has been benefiting from disruption at the competing Burrup plant in Western Australia, while fertiliser earnings surged due to favourable weather late in the season. Overall, the Chemicals, Energy and Fertilisers division reported a 14% lift in revenues to $874m and a 2% increase in operating earnings to $185m.

While Wesfarmers' underlying result was perhaps a little better than expected - notwithstanding the weakness in Kmart - the headwinds for retail appear to be strengthening. As we've seen for the grocery retailers this week, slowing sales and rising costs mean - at a minimum - weaker profit growth.

But the Wesfarmers' share price rose yesterday and, adjusting for the Coles demerger, it's now up 13% (plus dividends) since we upgraded the stock in April. We're expecting underlying earnings per share of around $1.75 in 2019, which means the stock is trading on a prospective price-earnings ratio of 20.

That seems a little high given the difficult outlook for retailers, but there's one source of potential upside that's not captured in the current multiple: acquisition potential. Based on Rob Scott's portfolio management so far, we're somewhat more confident about the company's acquisition strategy than previously. As we've said before, how well Wesfarmers buys will be a significant determinant of future returns from the stock.

Our Buy price looks a little conservative, so we're lifting it from $30.00 to $32.00. Further retail deterioration could cause us to change tack again, though, and our recommendation remains HOLD.

Disclosure: The author owns shares in Wesfarmers.

Note: Our Model Growth and Model Income portfolios own shares in Wesfarmers.

Note: The Intelligent Investor Equity Income Fund owns shares in Wesfarmers.