Will Wesfarmers Exit UK?

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This story features WESFARMERS LIMITED, and other companies.
For more info SHARE ANALYSIS: WES
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

Wesfarmers has announced material downgrades to expectations from its Bunnings UK & Ireland division, with several brokers suggesting the risk is growing for an exit from the UK.

-BUKI problems a distraction at a time when both Coles and Target are also under pressure
-Bunnings still expected to perform strongly in Australasia after industry consolidation
-Should Wesfarmers consider a share buyback?
 

By Eva Brocklehurst

Troubled by execution issues in its recently-acquired Homebase UK business, Wesfarmers ((WES)) has commenced a review of its UK strategy and will update at its briefing in June.

The company has announced a material downgrades to earnings expectations for Bunnings UK & Ireland (BUKI) and several brokers suggest the risk is growing for an exit from the UK in the medium term. The company has stated that all options are on the table.

BUKI is expected to report an underlying loss (EBIT) of -$165m. Wesfarmers will include $1.3bn in significant items in the first half result, comprising non-cash impairment of -$1.02bn on the acquisition of Homebase and a -$306m impairment for Target.

UBS now forecasts the UK operation to record around -$384m in cumulative operating earnings losses out to FY21 before breaking even in FY22, and suggests this delayed scenario may even prove optimistic given current trading conditions and loss of key management.

Brokers are now less confident about the outlook and expect growth will become harder to come by. UBS notes execution is deteriorating at company's flagship Coles supermarkets, amid increased competition in grocery items via Woolworths ((WOW)) and Aldi and discretionary items via Amazon. Meanwhile, consumer conditions are tough and the housing market is slowing.

Morgans points to the difficulties of expanding into a foreign country, despite the success with Bunnings locally, and agrees this poses a distraction for management during a time when both Coles and Target are under pressure. The announcement is likely to taint future acquisition opportunities, the broker agrees, particularly offshore.

On the positive side, Bunnings is still expected to performed strongly in Australasia following industry consolidation, Ord Minnett notes, and the Wesfarmers industrial divisions have improved because of cost savings and commodity prices, although revenue growth is difficult. Department stores are being led increasingly by Kmart, which remains a strong contributor to earnings.

While Macquarie acknowledges the outlook is problematic for both BUKI and Target, these divisions are less than 5% of operating earnings (EBIT) and the company is committed to a turnaround. Hence, with a reasonable value proposition and robust balance sheet the broker sticks with an Outperform rating.

BUKI

Macquarie expects, with the exception of refurbishments that are currently underway, Wesfarmers will make no more conversions of the original Homebase stores until a decision on the future of the business is finalised.

The broker explains the nub of the issue in terms of inventory, as Wesfarmers underestimated the customer response to the removal of soft furnishings (the prior Homebase range) and replacement with Bunnings-type hardware.

Moreover, most of the Homebase team were removed when the deal was completed, reportedly resulting in a lack of experience in this market. The main categories that are problematic include kitchens, flooring, tiling and plumbing. Conversions, with 19 already converted to Bunnings, have had a variable sales result but around a 40% uplift was generally noted.

The company also indicated that seasonality in the business should have been handled better. Underperforming stores in unprofitable locations will be closed down, calculated to be 20-40 from a total store base of 250. Macquarie expects the business will be in turnaround mode for some time and calculates break even in FY22, noting there are GBP1bn in lease liabilities across the network.

Deutsche Bank suggests, in some ways, this is a worse proposition than the case of Masters, as Woolworths had a large Masters property portfolio to sell whilst Wesfarmers has a large lease liability with Homebase. Also, Woolworths had a joint venture partner to share the pain.

Credit Suisse capitalises a prolonged period of losses, or an "embarrassing" exit, at -$2bn, equivalent to around 4% of the company's market capitalisation. Even assuming that losses in Homebase can be reduced, additional losses beyond FY18 should be included in the capital base for a Bunnings decision, the broker asserts.

Beyond this, the near term future depends on the maturing turnaround story, but Wesfarmers also has an underweight exposure to a strengthening infrastructure, the broker points out.

Citi agrees the prospect of an exit is escalating, estimating the cost would be around $1.1-2.2bn, equivalent to around $0.96-1.96 per share. Citi retains a Sell rating and maintains a clear preference for Woolworths.

Buyback

Macquarie asks whether the company should focus on rectifying internal performance issues and consider a share buyback. The broker estimates the company has around $4.0bn of balance sheet capacity to embark on a buyback, noting that Standard & Poor's has indicated its rating is unaffected by the impairments.

A buyback of that quantum would be around 4.6% accretive to earnings, Macquarie suggests, allowing for the positive spread between the company's earnings yield and the marginal cost of debt. The company has indicated that post cash proceeds being received from the Curragh sale, it may look to return capital to shareholders.

Given the amount of work, capital and time required to produce a satisfactory returns from the UK, Morgans suspects it likely that Wesfarmers will exit the business. The broker suggests the market would view this favourably, along with any announcement on capital management.

Credit Suisse finds it hard to envisage how Wesfarmers may outperform the broader market noting the stock is not particularly cheap. Industrials and chemicals need to do a lot of the heavy lifting and the broker does not believe, with the stock trading close to valuation, that a capital return or buyback would add materially to value.

Target

Trading conditions at conditions have been difficult and Wesfarmers indicates that, whilst the profit line has improved, it remains well below forecasts required to underpin the current carrying value of the business.

Target earnings may have improved in the first half but this is not a reliable indicator of the turnaround, in Citi's opinion. Sales productivity is depressed and expected to hit its lowest level in 18 years in FY18.

Direct sourcing and range rationalisation has boosted unit economics but the broker suspects it remains hard to attract customers back into the store, and this is ultimately required for sustainable turnaround.

FNArena's database shows one Buy (Macquarie), four Hold and three Sell ratings. The consensus target is $40.20, suggesting -1.8% downside to the last share price. This compares with $41.62 ahead of the update. Targets range from $37.00 (Deutsche Bank) to $43.92 (Macquarie). The dividend yield on FY18 and FY19 forecasts is 5.2% and 5.3% respectively.

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