Pop quiz: Which major retailing group will report a multi-billion dollar writedown in 2016? If you answered ‘Woolworths’ you’d be right – but only partly. In February 2016 the retailer wrote down its home improvement division by a whopping $3.2bn.
But last month Wesfarmers also announced it would make writedowns of up to $2.3bn in 2016. For Wesfarmers the problem divisions are department store chain Target and coal mine Curragh. It’s a measure of how differently Woolworths and Wesfarmers are perceived that the latter’s writedowns were greeted with a collective ‘ho-hum’.
Nor are Target and Curragh Wesfarmers’ only worries. The return on capital from the company’s Industrial and Safety division has slumped from 16% in 2012 to 4% this year as the resources downturn has continued to bite. With all this bad news, why is Wesfarmers still a market darling?
Most divisions looking weaker than before
Bunnings is the bright spot
Potential for disappointment rising
The answer is that the darling divisions more than offset the duds. We’ll turn to the darlings shortly but, at its recent Strategy Day, Wesfarmers outlined the steps it is taking to fix the duds. Guy Russo, the executive who drove Kmart’s margins from 3% in 2009 to 10% in 2015, has taken charge at Target. Based on a strategy of fewer promotions, greater direct sourcing and a simpler range, Russo is confident Target can improve from a loss in 2016 to more than $300m in operating earnings over time.
The resources-exposed businesses are more problematic. Industrial and Safety is undergoing a significant restructure that will combine multiple businesses into one. Within that division, Workwear, the clothing business acquired from Pacific Brands in 2014, has also slumped into losses. In this division management is fighting a war on multiple fronts.
In the Resources division, cash costs at Curragh have come down 35% since 2012 but management is seeking to reduce them further now the division is making losses. Unfortunately the mining downturn suggests both the Resources and Industrial & Safety divisions will deliver sub-par results into the foreseeable future.
For all Wesfarmers’ problems, though, investor attention remains focused on the darling divisions. Coles and Bunnings together account for more than three-quarters of the company’s value, so it’s a good job they’re performing well. Based on management comments at the Strategy Day, we’re less positive on Coles but more positive on Bunnings.
If you’ve been reading our Woolworths reviews you’ll know that margin expansion proved to be that company’s downfall. In fact, Chart 1 provides a warning for Coles.
Mind the gap
Our view is that the margin expansion in Coles’ food and liquor division is all but over. Woolworths has re-based its margins lower and Coles must heed its warning. Whilst Aldi’s grocery prices will always be cheaper – Coles management thinks by 10–15% at present – both major supermarket groups will need to ‘mind the gap’ more than they have in the past.
Reassuringly, though, Coles’ boss John Durkan agreed with our recent review of industry competition at the Strategy Day. Durkan thinks the market is rational and ‘will continue to be’; indeed, he specifically said ‘we’re different to the UK’. He highlighted Australia’s independent grocery sector – mainly supplied by Metcash - and that few customers were loyal. He implied that Coles could take market share over time by improving its offer.
Coles is also taking a different approach to site selection than Woolworths. New stores have to meet high hurdles, and Durkan noted ‘it can take five years to find the right sites’. By contrast, Woolworths seems more willing to open new locations, including small Woolworths Metro stores, which means it’s willing to tolerate cannibalisation.
All in all, we think Coles’ earnings growth is likely to slow significantly from the 10% average annual growth it reported over the five years to 2015. As that reality dawns on the market, any short- to medium-term disappointment could create a buying opportunity in Wesfarmers’ stock.
While the outlook for Coles looks worse than a year ago, the outlook for Bunnings looks better. In Australia, 70 stores are in the pipeline and management believes the broader building and construction market presents an opportunity. In the short to medium term, Bunnings is likely to take sales from Masters, even though management is assuming that Masters will continue to operate.
Even more significant could be Bunnings’ expansion into the UK. We weren't enthusiastic supporters of Woolworths Masters foray back in 2009 but the acquisition of Homebase – see Wesfarmers buys in Britain – is very different.
Bunnings has acquired $2.1bn of ongoing sales and 260 stores for just $660m. It’s already moving to ‘Always low prices’ and a do-it-yourself offer, and the turnaround potential looks significant. The first pilot store is expected to open by the end of this calendar year. Management is adamant that if the pilot stores don’t work, then the company won’t proceed with further investment.
Despite the upside from Bunnings, it’s hard to escape the conclusion that Wesfarmers faces a more difficult period ahead. Its resources-related businesses are troubled, the Target turnaround will take some years, and Coles’ earnings growth is tailing off. Broker consensus earnings per share forecasts of around $2.30 a share for 2017 could be too high.
Debt creeping up
Like Woolworths, Wesfarmers has also been letting its net debt creep up: from $4.3bn in 2011 to $6.1bn at 31 December 2015. It could be a sign of complacency. While a broader measure of solvency – the fixed charges coverage ratio – has improved from 2.2 to 2.4 over the past five years, debt always seems to get out of control at just the wrong time.
Perhaps that’s why managing director Richard Goyder highlighted at the Strategy Day that Wesfarmers does not operate a progressive dividend policy. While Wesfarmers dividends have risen from $1.50 a share in 2011 to $2.00 a share in 2015, the current payout ratio of more than 90% looks high.
So what does this all mean? In short, there’s some potential for Wesfarmers to disappoint over the next year or two. Slowing earnings from Coles, a delayed turnaround at Target or a dividend cut could see the share price come under pressure.
Of course, the share price and valuation are two very different things. Our valuation is largely unchanged from the sum-of-the-parts outlined in Wesfarmers counts on Chaney, although the potential upside from Bunnings UK means we're edging up our Buy price from $35 to $36.
With the share price now less than 10% away from there, we may yet get a chance to buy one of Australia’s 10 best businesses. Put Wesfarmers on your watch list but it remains a HOLD for now.