Coles And Coal: Why Wesfarmers Is Expensive

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

By Greg Peel

Yes, Status Quo have sold out. Do they care? Of course not. The band was already mostly a parody of itself by the early eighties and as ABC's Gruen Transfer explained last night, their mutually beneficial deal with Coles provides a lucrative opportunity. Fodder for the Chaser boys as well, but then every time those big red hands come out, even to be lampooned, Coles scores free advertising.

No one seemed surprised when Dawn French sold out too.

As the Gruen team went on to explain, the Coles “down, down” campaign has been an unqualified success. To the point the campaign will probably become a case study for future marketing hopefuls. And as stock market watchers have noted, Coles' successful turnaround under the Wesfarmers ((WES)) umbrella has translated into solid share price gains for the group. To draw upon another old ad campaign, “They said you'd never make it”. (Swan Lager, for those who can remember.)

Even the BA-Merrill Lynch analysts have been impressed. Merrills had always been highly critical of last decade's takeover of the Southcorp wine giant by brewing giant Foster's, forecasting disaster. Ultimately the analysts were right. When it came to the big Western Australian taking on Coles – a supermarket business so overwhelmed by its single main competitor Woolworths ((WOW)) that it was at risk of heading out the back door, Merrills was similarly dismissive from the outset. What did a conglomerate of agribusiness, coal mining, hardware and insurance (one of the last great mish-mash conglomerates that were once popular in the eighties) know about selling milk and bread? Woolies was so far ahead, the task of returning to a level of competitiveness seemed almost impossible.

Today, Merrills has a Buy rating on Wesfarmers – one of only two of the eight brokers in the FNArena database to do so. After a solid FY12 earnings result delivered in August, Merrills upgraded its target price for WES, citing a growing confidence in the business, better than expected quality, and impressive cash generation. Merrill's current twelve-month target of $36.50 is surpassed only by UBS' high mark of $36.70, in a range from $30.06 (RBS, Hold).

For the past twelve months Coles has initiated a price war with Woolies, and any other unfortunate sap who might sell household staples, and has won handsomely. Coles' like-for-like sales growth has gone from strength to strength, leaving Woolies in the dust. But we must remember, of course, that Coles was coming off a much lower sales base when compared to Woolies, which had a sales base at the time that seemed impossible to improve upon when  Wesfarmers made its move.

The bottom line is that the WES share price has risen from just over $28ps in April to around $34ps today. Mind you, the WOW share price has performed similarly, as investors have focused on defensive cash flow businesses. With Woolies now attempting to take on Wesfarmers in the Hardware Hell space, with Bunnings well entrenched, there's more than just supermarkets aligning the two competitors. But there is one glaring difference – Woolies doesn't mine coal.

Indeed, it appears that when stock market investors look at Wesfarmers now, they see Coles. Probably Bunnings as well (and maybe even K-Mart and Target), but really it seems that WES is just about retail and nothing else. Yet in FY12 WES derived around 12% of its earnings from its Curragh coal mine near Rockhampton in Queensland. Readers may have noted that coal prices have been under a great deal of pressure in 2012, and while Curragh produces both coking coal for steel production and thermal coal for power generation, both have seen significant price falls. And unlike the iron ore price that crashed recently, but has since rebounded somewhat, coal prices remain depressed.

It is a point not lost on the analysts at Deutsche Bank. Deutsche has been warning of the coal situation and its potential impact on WES for over a month now, and today the analysts have translated their concerns into hard numbers. They now forecast an average FY13 coking coal price of US$173/t, down 26% from their previous forecast, and an Aussie of US$1.03, up 4.7%. The result is a 50% downgrade to Wesfamers' coal division forecast earnings in the period, and a 22% reduction in the net present value assumption of the Curragh mine.

Coal may have only represented 12% of group FY12 earnings, but today's downgrades have translated into a 6.3% reduction in forecast group earnings for FY13 and 4.6% in FY14. This now means WES is trading at a PE of almost 17x on Deutsche's FY13 forecasts, “which we consider to be fully valued notwithstanding the continued margin benefit likely to be delivered by Coles”.

Deutsche has nevertheless retained its Hold rating and $33 target, which sits just above the FNArena database consensus target of $32.85. 

Back in August, post result, Citi also cited a 17x multiple when its analysts decided to downgrade WES to Sell. At the time, Citi was expecting slower earnings across all of Wesfarmers' supermarket, discretionary retail and resource divisions, and made note of the strong run in the share price. Credit Suisse maintained its Sell rating despite its belief in the longer term value offered by the group, again citing the solid share price run.

Interestingly, RBS Australia chose the same day to upgrade its rating to Hold from Sell. The WES share price has consolidated somewhat since and brokers in general have reined in their earnings forecasts to some degree. However, the real action in bulk material prices was seen over September.

The FNArena database currently shows two Buys, four Holds and two Sells for Wesfarmers on a target of $32.85, as noted. WES is trading at $34.48 as I write, making it a candidate for an FNArena Icarus signal warning (price exceeding consensus target, in this case by 4%).

While resource sector analysts have become a little more hopeful about Chinese iron ore prices, having correctly assumed the rapid price plunge would prove a temporary overreaction, they remain cautious over near-term pricing given China's excess steel inventories. They are more pessimistic about coking coal, not expecting a similar bounce. For thermal coal, the Chinese slowdown and the rise of the US shale gas industry will serve to keep a lid on prices.

For Wesfarmers, it may be difficult to retain the status quo.

 

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