Where Are The Returns For Wesfarmers?

This story features WESFARMERS LIMITED, and other companies. For more info SHARE ANALYSIS: WES

-Liquor segment of most concern
-Capital management, acquisition probable
-High returns potential in Bunnings
-Reduced resources impact on profile
 

By Eva Brocklehurst

Wesfarmers ((WES)) is tidying its books. The company will take a goodwill impairment on retailer Target of $680m and a provision of $94m for a restructure of the Coles' liquor division in FY14. The company has also signalled the range of pre-tax profits from the divestment of the insurance underwriting segment will be $1.04-1.08 billion.

The charges did not surprise brokers but reinforce the preception of challenges facing some parts of this diversified business. Wesfarmers expects Target's earnings to be $82-88m for FY14, an earnings margin of 3.9%, and Citi compares this with five years ago when the business earned a 9.4% margin. The broker values Target at $1.9bn, with a long-run margin of 5.6%. Target and Kmart, combined, represent 10% of the broker's enterprise value. Approximately two thirds of Wesfarmers' value is generated from its retail operations.

Coles' liquor segment is the main area of concern. The business manages only half the earnings margin of the company's supermarkets and sales productivity is very poor compared with rival Woolworths ((WOW)). Citi thinks the problems are structural and there will be no quick fixes. The broker retains a Sell rating for Wesfarmers. The market seems to be already factoring in a substantial recovery in the cyclical components of resources and discretionary retail, but Citi thinks any recovery will be further off.

The impairment and guidance for Target indicate clearing of excess inventory and a clean start to FY15, in Credit Suisse's view. There is now a better chance Target can improve its mix of merchandise and establish a better base for sales growth but capital management is what Credit Suisse is most focused on. After repayment of debt Wesfarmers will have around $1.7bn in cash from the insurance sale and, based on past practice, a special dividend of around 34c per share is likely. The broker thinks there is probably equal potential for the remaining proceeds to be used for an acquisition or fund a capital return.

In the absence of an acquisition in the next six months, UBS expects Wesfarmers to return excess funds to shareholders. Trading at around 19 times FY15 price/earnings forecasts and delivering an 8% three-year compound growth rate means the stock needs underlying earnings upgrades or an accretive acquisition to drive outperformance, in the broker's view. Weak trading after the federal budget limits scope for near-term upside and, with no acquisition imminent, UBS finds few catalysts on the horizon and retains a Neutral rating.

JP Morgan does not expect further goodwill write downs at Target but thinks any turnaround is long dated and more difficult to put in place compared with Coles. The broker think the price Wesfarmers paid for Coles group was high and only notes Kmart has generated a strong return in recent years. Coles is only now delivering returns above its cost of capital, while Officeworks has never exceeded and Target has disappointed on that front. Positives? JP Morgan thinks the turnaround at Coles has more upside and is increasingly confident of Bunnings' ability to generate both strong returns and more modest margin compression over the medium term.

Liquor provisioning has potential to improve returns for Coles. JP Morgan thinks the task is much more difficult than turning sharemarkets around, but not impossible. Moreover, taking a provision on the segment signals a greater priority is being placed on turning the liquor business around. Other concerns? JP Morgan finds a lack of valuation support in the stock's price and is wary of the challenges in the company's industrial divisions. A Neutral rating is retained.

Given the challenges in liquor, Deutsche Bank is not surprised that stores will be closed and stock written down. The Target impairment was not a surprise given weak earnings outlook. The broker thinks the improving food inflation outlook will be much more important in driving Wesfarmers' performance in future, because of the relative size of Coles. Macquarie was not surprised at the provisions either. The company has not hidden the fact liquor has been underperforming and has previously flagged a restructure to improve operational efficiency. The positive aspect for Macquarie in the Target write down is that it is not being driven by a material change in cash flow expectations.

On the subject of Wesfarmers' resources exposure, Goldman Sachs makes the point that this segment is now a very low contributor to earnings. Thus, while metallurgical coal prices appear to have found a floor and industry capacity is reduced, the sector is unlikely to have as significant an impact on the company's earnings profile as it has in recent years.

On FNArena's database Wesfarmers has one Buy, four Hold and three Sell ratings. The consensus target of $41.40 suggests 3.5% downside to the last share price. The dividend yield on FY14 and FY15 estimates is 4.8% and 5.1% respectively.
 

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