Is Growth Becoming Harder For Wesfarmers?

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This story features WESFARMERS LIMITED, and other companies.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

Brokers suspect that growth is becoming harder to obtain for retail conglomerate Wesfarmers in the face of a weak consumer outlook, slowing housing and increased competition.

-Will business diversity help offset increased competition?
-Diverging views on how Amazon will affect Wesfarmers
-How much more will supermarket margins be squeezed by competition?

By Eva Brocklehurst

Brokers suspect that growth is becoming harder to obtain for retail conglomerate Wesfarmers ((WES)) in the face of a weak consumer outlook, slowing housing and increased competition. The company's investor briefing signalled softer than expected summer trading for Bunnings UK and greater than expected price investment at Coles, driving downgrades to earnings forecasts. A return to profitability at Target is also likely to take longer than many expected.

Growth is becoming more difficult, driven by increasing competition in grocery (Aldi) and discretionary retailing (Amazon). This is compounded by weak consumer sentiment and a slowing housing market. Morgan Stanley recently downgraded Wesfarmers to Underweight on concerns about Amazon's entry – which it believes the market is underestimating, as well as the competitive outlook for Coles and a softer housing market affecting growth at Bunnings.

In contrast, Goldman Sachs observes diversity is a key strength of the business and provides a strong defence against the potential entry of Amazon and other e-commerce operators. The broker assesses that Coles, Bunnings, Kmart and the industrials business have a low susceptibility to disintermediation from online entrants. Combined, these businesses comprise 95% of current earnings.

The company has also brushed Amazon aside, stating it is just another manifestation of competition in the market and a lot of international retailers are already here. The company also believes the Australian retailer sector is large enough for other players as well as Amazon to remain relevant. Management considers its Officeworks business is well equipped to compete with Amazon, as it has a well recognised brand with a "low-price" guarantee across online and store-based channels.

Goldman Sachs considers Wesfarmers one of the best positioned and highest quality businesses under coverage in the retail sector and retains a Buy rating. The broker, not one of the eight monitored daily on the FNArena database, has a target of $48.50. Macquarie concurs, with an Outperform rating,  and ascertains that the quality of the assets and solid balance sheet will stand the company in good stead despite the sombre consumer outlook and a peaking housing cycle.

Citi downgrades FY17 forecasts for earnings per share by -2.4% and FY18 by -4.8%. The broker also reduces its outlook for coal earnings to reflect lower contract prices. This is partly offset by lower interest costs. Citi maintains a Sell rating and reduces its target by -7% to reflect the earnings downgrade for Coles and the department stores.

Morgans considers many headwinds in the short term are weighing on the share price although retains a belief that management can deliver satisfactory returns in the longer term.

Coles

Coles continues to aggressively invest in price, with the company indicating that this investment had almost tripled in the second half versus the first half. Citi now expects Coles earnings margins to fall to 4% in FY18 and cuts underlying estimates by -15% for FY17 and -7% for FY18.

The broker expects Coles will continue to feel pressure from the recovery at Woolworths ((WOW)) and, given the slow market growth for the Australian grocery industry, the gains by Woolworths are likely to come at the expense of Coles and other independent supermarket operators.

Despite the increase in price investment the broker remains of the view that the grocery market in Australia is rational from a pricing perspective. Morgans is more sceptical and questions the extent to which margins in the sector have to fall before pricing investment stabilises. Given continued pressure from new players over the next few years, the broker believes there is downside risk to margins for both major supermarkets.

Bunnings

Bunnings, domestically, is performing well but the new UK & Ireland business is still experiencing losses as Homebase is re-vamped and bad weather has hampered progress. Management expects to have four pilot stores by June 30 and 10 by the end of the year. Further investment will depend on the success of the pilot stores. Morgans expects the UK business to deliver an earnings loss of GBP26m in FY17, breaking even in FY20.

Goldman Sachs is confident about further growth in Bunnings in the domestic market as it targets adjacencies in home improvement and outdoor living. The broker estimates Bunnings has around 20% market share and is now benefitting from a more consolidated market following the exit of Masters. Goldman believes, given Bunnings' industry position, track record on returns and earnings growth forecasts, the business is significantly undervalued based on a peer multiple analysis.

Citi estimates that around 50% of Masters sales are likely to transfer to Bunnings given the store customer and format overlap, and market share gains will support sales growth as housing activity slows. Morgan Stanley is not convinced and believes the gain on the demise of Masters is less than previously anticipated, while the slowdown in housing will reduce growth in Bunnings sales and pressure margins.

Kmart And Target

Department store mergers at head office level for Kmart and Target are generating cost synergies but the turnaround is expected to take time. Management has targeted improvement of 20% in department store sales as the networks are optimised.

Citi estimates an 8% uplift could be generated through store closures and conversions but in order to reach the 20% target the combined business would need to generate 2.3% growth per annum in organic sales per square metre, well ahead of the -0.5% decline in the past seven years. The broker forecasts no sales growth per square metre from FY19-22 as the industry consolidates and Amazon enters the Australian market.

Kmart continues to do well but Ord Minnett observes that replicating the strategy at Target is proving ineffective and remains concerned that both stores cannot succeed at the same time. Given the challenges in the Australian consumer marketplace and the intense competition, the broker believes market scepticism around Target's turnaround is justified.

The database has one Buy recommendation (Macquarie), four Hold and three Sell. The consensus target is $40.65, suggesting 2.0% upside to the last share price. Targets range from $36.00 (Morgan Stanley) to $44.00 (Ord Minnett). The dividend yield on FY17 and FY18 forecasts is 5.5%.
 

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