More Capital Return From Wesfarmers?

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

– Wesfarmers now out of Insurance
– $3bn to spend
– Acquisition or capital management?
– Regulatory approval pending

By Greg Peel

The new management of Wesfarmers’ ((WES)) insurance business looked to be performing well, suggests BA-Merrill Lynch, and there were positive plans to grow the underwriting business through Coles. But the broker acknowledges that volatility in the insurance game is elevated. Insurance delivered $20m in earnings for WES in FY11 but only $5m in FY12. The broker thus understands the logic in divesting of the business.

WES sold its underwriting business to Insurance Australia Group ((IAG)) in December, pending regulatory approval (the ACCC has approved but NZCC approval awaits), immediately leading the market to assume the company would also divest of its insurance broking business. An IPO was touted, but WES has saved itself the trouble and cost with its announcement yesterday that the broking business is to be sold to US-based Arthur J. Gallagher & Co, subject to approval. This time approval needs to be forthcoming from the FIRB as well as the ACCC and the equivalent New Zealand bodies. The approval process could take several months.

Credit Suisse believes approval is likely to be given, although most brokers have elected not to adjust their forecasts until this becomes more clear.

The insurance broking business will be sold for $1.16bn and a pre-tax profit of $310-335m is expected. As to whether or not this price is a good one depends on which broker one takes a starting valuation from, which is dependent on that broker’s earnings forecasts. Suffice to say the price represents a multiple that is either at, or a bit above, Wesfarmers’ group multiple and either consistent with, or a bit better than, recent comparable local insurance sector sales, being those of Austbrokers ((AUB)) and Steadfast ((SDF)).

On that basis, both JP Morgan and CIMB would have liked more of a control premium while four other FNArena database brokers and Morgan Stanley suggest a favourable price.

But there’s little benefit in quibbling about price. Let’s just say it will do. And there’s not much point pining for lost earnings as the loss of business will be only modestly dilutive while the proceeds sit in cash. But they will not sit in cash for long, and that is the important element. The two sales combined – underwriting and broking – will generate around $3bn.

What will Wesfarmers do with the money?

The first thing to do is to pay down debt, not that the group is highly geared to begin with. WES cannot actually pay down too much debt given most of it cannot be retired for at least two years. WES could then pursue capital management, as it did last year via a 50c special dividend, or pursue an acquisition. Balance sheet strength means the company could re-gear its balance sheet and maintain its A- rating from S&P while still having $4.5m to spend on an acquisition, notes CIMB. WES could comfortably fund a $5bn acquisition without compromising the balance sheet on Morgan Stanley’s estimates while UBS suggests up to $7bn.

Brokers are mostly looking at the decision between capital management or acquisition as indeed an either/or proposition. But neither is without its obstacles.

A share buyback is unlikely while the stock trades on a 20x multiple. There would be little earnings accretion gained in paying up. And given Wesfarmers’ franking credit balance is actually negative, a dividend payout ratio above 100% is also unlikely in CIMB’s view. A capital return is the most likely choice if distribution is WES’ preference, CIMB believes.

Yet the announcement of the special dividend did not ultimately prove particularly popular with retail investors at the FY13 result, notes CIMB, which is surprising given for the last few years one would not want to be caught standing between a retail investor and yield. In this instance shareholders appear to be more keen on future earnings growth potential. The big miners and energy companies may be increasing their yields but only because they see no value in further growth at present. Wesfarmers, already a conglomerate of disparate businesses, could surely find a growth opportunity somewhere.

This is not a stroll in the park either. Macquarie believes WES is eager to redeploy capital into another acquisition (Coles has worked out rather well) but the group’s track record would imply WES is not going to buy a business just for the sake of it. Deutsche Bank suggests that given stretched valuations across listed assets, it will be difficult for WES to generate an immediate return above its weighted cost of capital on any acquisition, unless synergies are sufficiently attractive.

Wesfarmers currently owns all of Coles, Bunnings, Kmart and Target. Anywhere the group could find any synergies among similar businesses would never get past the ACCC, one presumes. Insurance has now been cast out, leaving the group’s industrial divisions and coal. The industrial divisions are challenged due to the slowing resources market and operational factors, notes JP Morgan. So even a “cheap” acquisition in this sector would likely not go over well with investors. That leaves coal.

CIMB believes the group’s decision is one of either one of returning capital or buying a metallurgical (coking) coal asset “at the bottom of the cycle”. WES has previously discussed a desire to evaluate acquisitions that offer economies of scale or downstream benefits, much like the coal reserve extension in January.

Credit Suisse, on the other hand, is not even entertaining the acquisition option. The “focus remains capital management,” the broker declares. Unlike other brokers, CS is not hanging around to wait to see what the regulators decide.

The broker is now basing its forecasts on the distribution of proceeds from the two transactions to shareholders through a combination of special dividends and capital returns. Specials of 46c and 21c will be paid in FY14 and FY15 respectively along with capital returns of $1,338m and $0.783bn. Throw in ordinary dividends, and shareholder returns will represent 10.0% and 8.9%. Credit Suisse seems rather definitive. Unlike other brokers, who are mostly waiting to see what happens.

Macquarie is nevertheless continuing to forecast a special dividend of 50c in the first half of FY15 although the broker notes that the group retains significant capital for deployment into acquisitions or further capital returns.

Despite the potential on offer from Wesfarmers’ divestments, not one FNArena broker can afford the stock a Buy or equivalent rating at the current trading price. The insurance businesses were sold at around a 12x PE but the group trades at over 20x. Coles and Bunnings are quality assets, suggests Citi, but the other 33% of enterprise value in the group is cyclical in nature. Multiples of over 20x are mostly afforded either to defensive high cash flow stocks or stocks with strong earnings growth trajectories.

There are four Hold and four Sell or equivalent ratings for WES on the FNArena database. Target prices range from $38.00 (Deutsche) to $45.00 (Credit Suisse) for a consensus target of $40.50, 4% below the current trading price.
 

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