Wesfarmers Travels Well On A Wide Road

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

-Strong growth segments continue
-Weak spots are coal, chemicals, industrials
-Target needs work
 

By Eva Brocklehurst

Wesfarmers ((WES)) briefed the investment community recently on its many and diversified businesses. The company did not provide any news on capital management, to the disappointment of some. Instead, as JP Morgan observed, the company identified a different, albeit consistent, destination for surplus capital – its own businesses.

Coles: This is a battleground for Wesfarmers. BA-Merrill Lynch believes too much was paid for the assets in the first place. Nevertheless, the outlook for Coles has improved and momentum appears to have been regained. In the broker's view, Coles is increasingly extracting efficiencies from the business, which is driving earnings growth, and is clear on what the customer offering is all about. The business has multiple drivers of growth. Like-for-like sales are ahead of the market, there are new store roll-outs and gross margin expansion through the private label.

Macquarie was amused at the developments in the ongoing price war with Woolworths ((WOW)). Coles said prices were consistently lower, around 1-1.5% since the Down Down ad campaign was launched in 2009. Woolworths apparently told suppliers much the same thing last week, that its prices were 1.5% lower than Coles. Price wars aside, JP Morgan sees the turnaround on track with new growth initiatives being explored, including Flybuys and Coles Insurance. Liquor remains a significant drag on margins for Coles, at less than 10% of earnings, despite being over 10% of sales. This is a contrast to Woolworths, where JP Morgan suspects liquor margins are close to group food & liquor margins, with liquor comprising over 10% of earnings while being 15% of sales for that division.

Bunnings: This home and hardware division wins the blue ribbon in terms of success for Wesfarmers. Merrills found the earnings outlook was materially more positive than had been factored in. Bunnings is expected to deliver 9% earnings growth in FY14 and FY15. This stand-out is one of the key reasons Merrills is the one broker on the FNArena database with a Buy rating for Wesfarmers.

Bunnings is aggressively rolling out new stores, some 90 are expected to open in the next few years. Credit Suisse believes Bunnings demonstrates a big advantage from its brand strength which enables it to bring stores to profitability early in their development. Expansion is likely to improve both the quality and quantity of space as larger footprint warehouses in inner suburban areas support product expansion initiatives. This expansion will increase barriers to competitor expansion, in Credit Suisse's view, and additional commissioning costs are unlikely to significantly impact profit.

Kmart: Operating well. Growing volumes will continue to help the discount store negotiate more favourable pricing. Kmart is currently undertaking around $1 billion in direct order shipments compared to just $150m three years ago.The realisation of further price reductions would transfer further market share to Kmart particularly if the pricing differential widens further, in UBS' view. Other growth drivers include 36 planned new stores with six in FY14, introduction of new product categories, new store formats and the removal of the annual toy sales – this will have a $50m sales impact but earnings accretive.

Target: Struggling to find a firm place in the line up of discount department stores and the brokers note much responsibility for solving operational problems will fall to the new divisional CEO, Stuart Machin. Additional costs to clear inventory, close off-site storage and rectify other infrastructure issues will impact on FY14. There are early indications that the strategy may be to increase the value emphasis, returning Target to its roots. Here, UBS is in agreement, believing the strategy to move Target to a mid-market range confused shoppers. Nevertheless, there is the potential overhang to profit forecast of a substantial investment in the supply chain over the next few years. The key advantage that needs to be leveraged, in JP Morgan's view, is the brand. The broker expects much better advertising of the brand in future, although attention will be first directed to products, stores and operations.

Officeworks: The office supply segment faces significant challenges, with weak market trends and negative changes to consumer behaviour. Depressed consumer and business sentiment as well as continued deflation is expected to weigh on top line growth and margins, in Deutsche Bank's view. Management hailed the importance of online trading in the category. Officeworks' web store is now the biggest store and generates sales of over $150m per annum with online transactions growing at over 25%. As a driver of growth, Citi notes the company's desire to expand beyond office products to a wider $30 billion market that includes technology products and furniture.

Coal: Soft outlook here. BA-Merrill Lynch is concerned about the deterioration in this business, hit by lower pricers and higher costs. Yet, coal is expected to generate around $100 million more in earnings than the broker had previously forecast. Credit Suisse suggests the main avenue to add value strategically is to take a view on the medium-term coal price. The plan to expand capacity for metallurgical coal exports to 10mtpa is subject to improving market conditions, which suggests to the broker a less than confident view on price at this point in time. Small scale acquisitions are being contemplated but, given the demand outlook doesn't support capacity expansion, this seems opportunistic in nature, suggests Credit Suisse.

Insurance: The underwriting business is trading well, notes Macquarie. Premium rate increases in Australia and New Zealand have averaged 6.9% and 6.2% respectively. Personal lines business through Coles now includes more than 200,000 policies. Management expects stable risk adjusted rates for the next renewal season. JP Morgan also notes the Coles brand and growth in distribution is the highlight here.

Chemical: This division is challenged by the downturn in the mining industry. UBS notes the only positive areas referred to in the briefing were the sales of sodium cyanide remained strong and the recovery in grain prices should support fertiliser demand.

Industrial: Business in industrial and safety products is tough. There is downside risk to trading in these products because of tightening of capital expenditure and cost control by mining and manufacturing customers.

So, why is Merrills the only one with a Buy rating on the FNArena database? There are two Hold and five Sell ratings. It's because of Wesfarmers' valuation. While most brokers contend the main businesses are strong, and there is an appetite for quality companies with attractive yields, the risk/reward benefit is just not there. The consensus target price is $39.22, suggesting 1.8% downside to the last share price. The dividend yield on consensus earnings forecasts is 4.4% for FY13 and 4.8% for FY14.

See also, Target Downgrade Sparks Discounting Fears on May 20 2013.

 

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