Great Result From Coles!

This story features WESFARMERS LIMITED, and other companies.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Wesfarmers’ ((WES)) first half result gave brokers a bit of a shock. The story ahead for the conglomerate is really one of coal, Coles and cost of funds. In the case of Coles, most analysts were unprepared for what Christmas means to retailers. The five weeks of Coles performance incorporated into Wesfarmers’ result straddled the Christmas period, influencing earnings for the supermarkets and also Coles’ other operations, Target and Kmart.

In short, the $350m of earnings before interest and tax (EBIT) generated by the Coles businesses represented 30% of all the EBIT achieved in FY07. That looks like one helluva turnaround. However, analysts are quick to point this seasonal period is as good as it will get until the next one, and as such earnings have to be considered in such a context. But they still fell a long way short with their forecasts.

The question is thus: How much can we take out of this? There is a mixture of enthusiasm and scepticism from analysts. However, when we’re talking Wesfarmers we’re talking a diverse conglomerate of which Coles has become simply a member, albeit a very significant one. There are also the “legacy” businesses, which all performed well in the first half, and Bunnings hardware, which also surprised analysts with a strong performance in the face of a potential retail downturn. And then there’s coal.

As has been well documented by FNArena, disrupted global coal supply has caused spot prices to skyrocket recently, and ongoing problems are such that analysts now expect contract price increases this year in the order of 100%. This is clearly a positive for Wesfarmers that must be considered alongside any supermarket performance. But there’s not much uncertainty about coal, whereas the market is waiting with baited breath to see whether Coles can be saved.

So the first signs are very good according to most analysts, seasonality aside. The important division of Food & Liquor improved, from a very low base, and analysts have confidence in the new management. The important thing is that Coles is no longer bleeding money. The shock EBIT result also reflected encouraging progress in cost reduction. Macquarie notes one cannot expect to improve a business without first addressing costs, and thus the effort so far is commendable. Furthermore, Wesfarmers took what UBS describes as a “once in a lifetime opportunity” to make $389m in contract provisions (leases etc) which it notes Coles could never afford to do. Analysts agree this is a good move although it does help to make the result look better.

Both Deutsche Bank and GSJB Were thought the Coles result (along with the coal outlook) was enough to upgrade their Wesfarmers recommendations to Buy. Both believe that while there’s still a very long way to go, the Coles turnaround story has gained some traction. Macquarie (Outperform) and Citi (Buy) agree, so no change to their already more optimistic ratings.

ABN Amro (Hold) has long said Coles will prove a “company defining” acquisition for Wesfarmers, but has taken a more circumspect view on the turnaround story. Potential headwinds are building in the retail sector given interest rate rises, although the Bunnings result, for example, does not suggest too much of an impact, so it remains to be seen whether Target and Kmart feel the pinch. UBS (Neutral) is yet to be convinced, and has raised the issue of cost of funds.

Wesfarmers had a net debt of $10.9bn at the end of the period, with up to $6.5bn likely to be refinanced by June/July. Management is confident it’s a case of “when” and not “if” refinancing will occur, and is not too concerned about the cost blow-out. However, UBS forecasts a 19% increase in interest cost in FY09.

The two brokers who were not influenced by the result were Merrill Lynch (Sell) and JP Morgan (Underweight). Merrills rather quickly dismissed the seasonality of the Coles performance and believes it’s going to take longer to turn Coles around than others expect, and at a greater cost. JP Morgan raises the ugly spectre of competitor Woolworths ((WOW)), who is still turning the knife even as Coles tries to get to its feet.

Despite the strong result, and subsequent earnings increases (which included analysts taking the opportunity to raise coal price forecasts), the average target in the FNArena database slipped slightly from $42.95 to $42.28. Not much should be read into this, as brokers have been using the result season as a smokescreen to reduce a lot of targets following market weakness. What is more significant is the range of targets, from $37.00 (JP Morgan) to $49.53 (Deutsche Bank). Deutsche actually raised its target, as did UBS. It just goes to show analysts are split on the Coles outlook story.

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