Wesfarmers: Capital Return Next?

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

-Benefit to IAG outweighs price
-Some regulatory concerns probable
-What will Wesfarmers do with funds?
-Wesfarmers shares remain expensive
 

By Eva Brocklehurst

Diverse conglomerate Wesfarmers ((WES)) plans to sell its insurance underwriting business in Australian and New Zealand to Insurance Australia Group ((IAG)). Brokers consider the price is full – $1.85 billion – and at the top of the insurance earnings cycle. If the sale goes ahead, and it's subject to a number of regulatory approvals, both locally and across the Tasman, it will simplify Wesfarmers' offering, a little. The company will still retain its insurance broking side and has done a deal with IAG for Coles supermarkets to retain the insurance distribution channel for 10 years.

CIMB considers the strategic benefits to IAG outweigh the high price, as this acquisition secures a major business that can assist the company's domestic growth strategy until the Asian business lends more support. The Coles agreement also opens up a new distribution channel, while removing a threat in motor insurance, although the broker does wonder whether that channel could cannibalise existing business. The deal raises IAG's gross written premium by 18% and gives it a leading position in the intermediated insurance market in Australasia.

That's if it secures all the regulatory approvals required. Credit Suisse notes IAG's attempt to frame the market share debate around an "intermediated" distribution view suggests there's some concerns regarding regulatory approval. Citi thinks the deal may drag out as it's not an easy case for the Australian Competition and Consumer Commission (ACCC). Also, the acquisition will increase IAG's NZ exposure in the intermediated business to 40% of market share. Macquarie observes that competition approval is likely to focus on certain lines of business, potentially rural, but the market is difficult to define.

Credit Suisse thinks the timing makes sense for IAG. While premium rate increases have slowed and will continue to slow, the benefits from the acquisition lie in the significant reinsurance savings and improving the efficiency of the underperforming operations. The deal also gives IAG access to what the broker considered was its biggest threat to personal lines, Coles. The acquisition is not without risk, as a large part of the savings lie with increasing the retention of the acquired business and realising reinsurance synergies. There are a number of commercial players in the market looking to grow market share in coming years and Credit Suisse anticipates they will not make integrating the Wesfarmers' business easy for IAG.

Morgan Stanley's view is along the same lines. The strategic rationale is sound as IAG becomes number one in Australian commercial lines, with 24% of the market as the structure improves. Also, it protects the company's personal motor franchise, where the broker thinks Coles was a real threat. Deutsche Bank is a little cooler about the deal. While it may help plug an earnings growth gap after FY14 as the insurance cycle turns, the broker questions the sustainable benefit relative to a cheaper, albeit slower, organic approach to growing commercial lines. Macquarie finds the strategic rationale sensible, consolidating a market with a high degree of product and geographic overlap.

The profit on the sale is around $700-750m so the natural question is, what will Wesfarmers do with the money? UBS considers capital management the most likely scenario, or an acquisition, given that, after this divestment, Wesfarmers will have in excess of $4.6bn in unused facilities. Alternatively, buying back $1.5bn in shares would be around 0.8% accretive. CIMB thinks, at the current share price, the accretive value of a buy-back is not worthwhile but the lack of franking credits means a dividend increase is also unlikely. CIMB wonders whether Wesfarmers will buy a metallurgical coal asset at the bottom of the resources cycle. The company has signalled it likes the opportunity for counter cyclical investment, having previously discussed a desire to evaluate acquisitions that offer economies of scale or downstream benefits.

Wesfarmers has just sold its 40% interest in Air Liquide for approximately $100 million. Is it sizing up another deal? Credit Suisse doesn't think so, given the company's discipline regarding fundamental valuations for acquisitions. The rise in markets over the past year and low debt costs are more likely to lead to acquirers paying a high price. Moreover, with Wesfarmers having acquisition capacity of $2-3 billion, it makes an acquisition only moderately material for the group, in the broker's opinion. BA-Merrill Lynch believes both businesses – insurance underwriting and Air Liquide – were generating earnings that looked unsustainable into the future, without sizeable amounts of capital being invested.

CIMB has decided the deal looks good on both sides and upgraded recommendations for both stocks to Hold. Macquarie likes the sale price Wesfarmers stands to receive and thinks it should provide the opportunity for another capital return. The broker upgraded the stock to Neutral from Underperform. JP Morgan considers Wesfarmers is well managed and active in returning capital but lacks valuation support so Underweight is the way to go. Citi thinks Wesfarmers is expensive and retains a Sell rating. The sale of insurance underwriting removes a business that was highly volatile, in Merrills' view, and one where shareholder interest and understanding was low. The broker is upbeat about the growth for the stock and remains the FNArena database's only holder of a Buy rating on Wesfarmers.

Brokers have tweaked price targets for Wesfarmers in both directions following the news, as they grapple with whether the stock is still expensive. Most seem to concede it is. The new consensus target on the FNArena database is $42.17 and is level pegging the last share price. This compares with $41.38 ahead of the announcement. The targets range from $34.60 (Citi) to $53.00 (Merrills). Wesfarmers' dividend yield on FY14 forecasts is 4.6% and for FY15 it's 5.1%. The stock now has two Buy ratings, three Hold (with two of these being upgrades) and three Sell.

IAG's consensus price target has also risen, to $5.75 from $5.64 beforehand. The new target suggests 5.8% upside to the last share price. IAG has one Buy rating (Macquarie), five Hold and two Sell. The dividend yield is 5.0% on FY14 forecasts and 5.3% for FY15.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms