Wesfarmers Dividend Likely Under Pressure

This story features WESFARMERS LIMITED. For more info SHARE ANALYSIS: WES

-Competition intense for Coles
-Target, UK strategy considered sound
-Yet risk of credit downgrade
 

By Eva Brocklehurst

Brokers increasingly suspect Wesfarmers ((WES)) may have to reduce its dividend, as the near term holds some negatives for several divisions and there is competitive pressure on its major earner, Coles. The company's strategy briefing contained few changes, with no formal guidance as usual, but brokers continue to reduce sales growth forecasts for Coles amid increasing evidence of price competition.

Morgan Stanley observes this to be the case, with the company indicating fresh food deflation has accelerated in the June quarter, yet volumes are unchanged. Management asserts strong seasonal growing conditions are behind the deflation and does not expect this to continue beyond the near term. Yet, the broker maintains, even outside of fresh food, prices are falling month to month. Morgan Stanley also notes Coles continues to increase the proportion of products sourced directly and this is driving improvements in its buying terms.

While not quantifying the magnitude, management expects there are more cost savings to be had at Coles, and savings are expected to be reinvested in price and promotional activity. Management remains confident in a rational supermarket playing field, which somewhat surprises UBS, as this market is growing at half the pace of 10 years ago and industry profits are falling for the first time in over 10 years. The broker believes the rate of earnings growth at Coles is at risk into FY17 if competition is increasing.

Ord Minnett suggests concerns around lower earnings growth at Coles are now better appreciated by management, and the supermarket, Bunnings, Kmart and Officeworks, are attractive features of the stock. Hence, while valuation support is modest, the dividend yield and underlying earnings growth remain appealing in a market where attractive investment options are few.

Moreover, Credit Suisse does not believe there is a major issue for the balance sheet, unless there is a sudden burst in capital expenditure, which is unlikely. Still, until the Target and Homebase (UK) businesses are transformed, the company is considered at risk of a credit downgrade, although the broker does not envisage a one-notch downgrade will be an issue.

Without the benefit of asset sales, Credit Suisse believes the dividend pay-out ratio needs to fall to 70-75% to be cash neutral and observes the choice is between doing something in FY17 or smoothing the outgoings until profit grows. Morgan Stanley also considers a dividend reduction is inevitable. The company has signalled it does not operate a progressive dividend policy, aiming to grow dividends over time dependent on earnings, franking, liquidity and the credit rating. Given the outlook for these factors, the broker suggests a reduction in the dividend to $1.80 a share from $2.00 is likely in FY16.

Deutsche Bank takes up the call as well, believing management will take action to preserve the credit rating. Moreover, supply-driven fresh deflation should weigh on Coles while wet weather could also have a temporary dampening effect on Bunnings earnings. Deutsche Bank now assumes a final dividend of 89c versus $1.09 previously, an 18% reduction on the prior year.

The profit improvement strategy at Target appears straightforward to Credit Suisse, in that management intends to reduce the range as well as re-badge some stores as Kmart. Citi notes Target will follow Kmart, taking direct sourcing of product offshore to 70% of sales from the current 40%. Deutsche Bank considers the near-term outlook negative, with an additional $100m in inventory overhanging Target, but the longer-term strategy appears feasible.

Morgan Stanley asserts aspirations in terms of sales growth, margin and returns are the same as back in 2010 and the near-term looks challenging, given the excess stock that needs to be cleared and the fact that a third of stores are currently making a loss. UBS, on the other hand, gains more comfort from the briefing in terms of management's ability to turn Target around without adversely affecting Kmart.

A measured approach is being taken in the case of the UK expansion of Bunnings, with only pilot stores to be rolled out before Christmas. When those stores have been proven a full conversion will take place. Meanwhile, Credit Suisse observes better delivery from the integration of industrial and safety divisions, while brokers contend the resources division is not expected to significantly improve until coal prices turn higher.

FNArena's database has one Buy (Macquarie, yet to update on the briefing), six Hold, and one Sell (Citi). The consensus target is $40.48, signalling 0.7% downside to the last share price. The dividend yield on FY16 and FY17 estimates is 4.7% and 5.0% respectively.
 

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