Soft Quarter Signalling More Weakness For Wesfarmers

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Brokers raise the spectre of whether soft September quarter sales numbers for Wesfarmers, particularly at Coles, are a sign of more weakness to come.

-Main negative is the deceleration of sales growth at Coles as Woolworths steps up price investment
-Sales growth at Coles now more difficult to obtain and expected to be modest
-Resources business seen doing the heavy lifting for Wesfarmers at present
-Uncertainties also prevail in the fashion, hardware and resources
 

By Eva Brocklehurst

Brokers raise the spectre of whether soft September quarter sales numbers for Wesfarmers ((WES)) are a sign of more weakness to come. Sales were weak across the main divisions. Food and liquor grew 1.8%, which represents the worst growth in several years. Bunnings slowed to 5.5%, as a result of clearance activity at former competitor Masters and a softer market, which are acknowledged to be temporary factors. Target's like-for-like sales slumped 22% while Kmart was encouraging, growing sales 8.2%.

The main negative was the deceleration in sales growth at Coles supermarkets. Management suggested this was driven by slower market growth as well as intense competition. Deutsche Bank warns there are risks in calling one quarter a trend, but believes competitor Woolworths ((WOW)) is improving in an environment where deflation is constraining market growth, while Aldi continues to gain share.

The broker does not believe there was a sharp market-wide decline in consumption volumes, but looking at the three consecutive quarterly declines in like-for-like growth, suggests this does coincide with the improvements Woolworths has made, even if it just means Woolworths is now “less bad”.

Overall, the broker contends that the sustained run at Coles has been supported by a strong top line, which has enabled the supermarket to provide incremental value for customers and grow or, at the least, preserve margins. Sales growth is now likely to be difficult to obtain, which could undermine this value loop that has been crucial to the success of Coles. With Coles being the main driver of Deutsche Bank's valuation the broker's rating is downgraded to Sell from Hold.

Cash generation is sound for Wesfarmers overall, Ord Minnett asserts. Bunnings is able to continue to generate a strong return on capital through continued earnings growth and capital recycling. The value focus and cost reductions at Coles are expected to position it well to address a challenging competitive backdrop. Still, the broker expects only modest earnings growth in the near term.

Industrial and resources divisions are improving, although this carries some risk and weighs on the price/earnings multiple in Ord Minnett's calculations. While accepting that blaming the weather is a weak stance, Macquarie's recent channel checks confirm the comments from Wesfarmers that a cold and wet spring has adversely affected apparel, home improvement and supermarket sales.

Resources business is doing the heavy lifting for Wesfarmers at present but it, too, was affected by weather, with total production down 11.8% on the prior quarter. The lower production will delay the benefit of higher coking coal prices but the company is expecting to break even in the first half. The first half is lining up as a tough period the broker believes, with risks to earnings increasing, but the longer-term proposition of strong balance sheet, earnings growth and dividend yield remain intact.

Macquarie is one of the more optimistic regarding Coles, doubting the supermarket has ceded share at this stage, although acknowledging it will need to to do more to offset the increased aggression in the market in recent months.

The broker does not envisage Coles straying from a long-held strategy of leading the market on value, which implies price leadership will not be given up lightly, although it could be at the cost to margins over the medium term. Macquarie forecasting a 10 basis points EBIT (earnings before interest and tax) decline in food and liquor over FY17 and slower comparable store sales growth of 2.3%.

Target's turnaround remains uncertain as brokers note the chain exists in a tough fashion segment. Credit Suisse expects around a 10% re-basing of sales in FY17 and, if Target successfully moves more towards an EDLP (Every Day Low Prices) model, the sale price offset could feasibly be around a three percentage point fall in markdown and supplier costs over time.

Credit Suisse would like to scrutinise the Woolworths and Metcash ((MTS)) results to determine the extent to which the slowdown in Coles was competitively driven. Pricing behaviour in food appears rational, given that Woolworths has dropped a significant profit into rectifying a poor price position. That said, the risk is that Coles moves its focus to near-term profit requirements.

Based on a circa 10% decline in fuel volume, the Coles convenience business has probably dropped 5-10% in value due to the acquisition of Shell's business by Vitol, the broker estimates. A reduction in the decline in gross margin offsets the earning impact of lower sales volumes in Coles in Credit Suisse forecasts for FY17.

Morgan Stanley reduces profit forecast for Coles by 12% and, while the non-food retailing business have also slowed, these are less of a concern given strong market positions. The broker reduces margin estimates significantly, estimating 4.6% for FY17 margins versus Woolworths at 4.4%.

The main question for UBS is what Coles does in the face of the heightened competition, considering it is driving the structural shift in the industry, as well as the impact slower sales will have on margins. The broker forecasts Coles to grow market share at 12 basis points per annum over FY16-20, yet also considers it increasingly challenging for Wesfarmers to maintain current rates of momentum in both Coles and Kmart into FY17. UBS believes Wesfarmers is fairly priced at current levels, given uncertainty over housing (Bunnings), grocery (potential price war) and the resources business.

The consensus target for Wesfarmers on FNArena's database is $41.59, signalling 1.8% in upside to the last share price. Targets range from $38.00 (Deutsche Bank) to $45.00 (Ord Minnett). The dividend yield on FY17 and FY18 forecasts is 5.0% and 5.2% respectively. There is one Buy rating (Macquarie), five Hold, and two Sell.
 

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