Wesfarmers: Who To Believe?

Array
(
    [0] => Array
        (
            [0] => ((FGL))
            [1] => ((WES))
            [2] => ((WOW))
        )

    [1] => Array
        (
            [0] => FGL
            [1] => WES
            [2] => WOW
        )

)

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

By Greg Peel

From the day that brewer Foster’s Group ((FGL)) even considered acquiring wine giant Southcorp the analysts at Merrill Lynch were vehemently opposed to the idea. The acquisition went ahead, and for three years the vitriol from Merrills never ceased. Southcorp would not prove an international company-making acquisition as Foster’s management had hoped, the analysts railed, it would eventually prove company-breaking. Or at least it would lead to the Foster’s share price halving over time.

The fact that Merrills’ analysis proved correct is enough to send a shiver down the spine of any Wesfarmers ((WES)) shareholder, for with regard to last year’s acquisition of Coles, Merrills’ analysis has a familiar ring. As soon as Wesfarmers started looking at the Coles balance sheet mid last year, Merrills started ringing the warning bells. Only a rising coal price kept the analysts from moving to a Sell rating, until in July, when the analysts caved in. Coal prices kept going to the moon, but Merrills held that Sell (later to become Underperform following a change in ratings definitions) and has held it ever since.

At the time of acquisition, right through to today, other brokers have been less committed. The general feeling at the time of the Coles acquisition was one of needing to turn around the Queen Mary, but analysts were for the most part only prepared to call it a 3-5 year story that may or may not work. Hold was a popular rating. Then the credit crunch hit, and the spotlight swung away from Wesfarmers. It swung back again in force in early to mid 2008, but this time because the coal price was tripling.

And this is where analysis of the disparate conglomerate that is Wesfarmers becomes a headache for the analysts. In comparing Foster’s acquisition of Southcorp, one could make the simple observation that beer and wine fit neatly under the one heading of Beverages. Part of Merrills’ argument was, however, that beer and wine are very different, and as such a successful chalk-maker was about to stumble foolishly into the cheese business. But when it comes to Wesfarmers, there is little to suggest the businesses of coal production and supermarket management have anything in common whatsoever. On that basis, an investor might see why such an acquisition is fraught with danger.

But Wesfarmers businesses are, and have been for many years, a random collection of chalks and cheeses – from coal to agricultural products, hardware retailing to insurance – and the company had so far proven a success. Thus the acquisition of Coles did not seem like such a stretch, compared to, say, a pure play coal producer suddenly deciding groceries looked like fun. But it was no small acquisition, and at the time Coles was on its knees – the vanquished partner in the duopoly with uber-successful grocer Woolworths ((WOW)). This should have suggested a fire-sale price, but once brokers came to appreciate just how much money Woolies was about to spend to ensure unending dominance over its victim, opinions wavered further. Wesfarmers has since been a story of coal and Coles. The former’s influence over the latter has ensured most brokers are keeping those Hold ratings at present.

The spotlight swung back to Coles again, and away from the now settled coal price, when Wesfarmers reported its full-year earnings in August. What hit analysts like a slap in the face was the apparent shortfall in the company’s working capital. It was clear that Coles was the culprit. Merrills saw blood, and has since gone in for the kill.

“We are concerned the financial well-being of Wesfarmers has been deeply compromised by the acquisition of Coles,” the analysts said earlier this month. “We are very concerned with Wesfarmers’ cash flow and balance sheet position,” they added  couple of days later. And yesterday it was a case of, “This could be serious”.

Merrills has moved from Orange Alert to Red Alert  in the space of a couple of weeks because now Wesfarmers’ offsetting factor is under threat – spot coal prices are falling. In short, the analysts warn that if coking coal prices fall to US$220/t and thermal coal prices to US$110/t in the next round of negotiations in 2009, Wesfarmers may have to be broken up. That is how dire the cash flow situation has become.

These are price falls of 30-35%. Given other commodities (such as oil) have already posted such price moves recently, one might suggest Merrills fears have foundation. But this article is not intended to argue the case for coal prices. It is to argue the case for Coles’ prices.

One is driven to ask: Have the Merrills analysts simply had a taste of blood? Did their victory over Foster’s leave them baying for more?

The reason one might enquire, is because there are two brokers currently holding diametrically opposed views to that of Merrill Lynch. Both Citi and GSJB Were have a Buy rating on Wesfarmers. Weres even has Wesfarmers on its “conviction list”.

Weres has argued from the outset that the Coles acquisition should prove a positive one, “but there is a long way to go and many challenges ahead”. Citi doesn’t keep conviction lists, but its analysts are as vehemently positive on the Coles acquisition as Merrills’ are negative. It all comes down to a matter of timing, they suggest.

This is not a case of timing any ultimate Coles turnaround. It is simply a case of timing with regard to that cash flow figure that so shocked brokers back in August.

Merrills is fixated upon a $661m shortfall of working capital in the FY08 result, and sees it as the basis of their argument as to why Wesfarmers is in danger of running a significant negative cash flow right through to FY10. Wesfarmers’ management explained away the $661m as a matter of seven and a half months versus eight. Coles had been on the Wesfarmers books for seven and a half months, but the creditor payment cycle reflected eight months. In other words, 30 June fell when inventories reflected only seven months and payment for inventories, eight. And furthermore, inventories at the time of acquisition (November) were reflective of the usual pre-Christmas excess. “It would all come out in the wash eventually'”, is what management was trying to say.

The Citi analysts agree. When you consider that Coles builds in excess of $500m of inventory each week up to Friday, but makes payments to creditors only on a Monday, a timing difference thus occurs. And this timing difference can account for over $400m of Coles working capital deficit. At least that’s the way Citi sees it.

Merrills is not buying it. They can see how that timing difference can influence accounting from the first half results to the second half, but not the full-year (even though that was only seven and  half months and not twelve). The analysts have poured over the books, and noted that Coles holds inventory for an average 51 days, and pays creditors on an average of every 31 days. By contrast, Woolies’ inventory last only 30 days and payments are made every 35 days. In other words, Woolies is running cash flow positive and Coles cash flow negative. This is enough for the analysts to declare:

“Wesfarmers appears not to understand working capital”.

That is a neat summary of why Merrill Lynch thinks Wesfarmers may be going to God.

Having dismissed fears of working capital shortfalls as being all in the timing, Citi builds its positive investment thesis on inherent upside for Coles which is not being granted any value within the current Wesfarmers share price. A successful Coles turnaround is a free option in the price, the analysts believe. And they are convinced Coles will be turned around.

Given its pre-existing retail businesses (most notably Bunnings), and combining the Coles group of businesses (including K-Mart, among other), Citi notes that Wesfarmers is Australia’s biggest retailer by floor space. Yet at present, Citi calculates that this floor space is being implicitly priced at a 62% discount to Woolworths’ floor space. Thus while Woolies might being ploughing substantial amounts of capex into its stores, a company that has reached such a height of its game will have trouble improving its profit margins from here. Coles definitely needs to spend big on its stores as well, but at a 62% discount to date, Citi implies that the only way is up. Coles has significant upside in its margins.

Crunching down such duopoly relativities to a comparative multiple, Citi calculates Woolies is trading on an FY09 PE of 19.1x while the Coles business trades at only 17.1x. In short, Coles has a lot of room for improvement and Woolies doesn’t.

So there you have it. Citi assumes that Coles now has the right people behind it to run the shop, so a turnaround should be easy enough given the very low starting point. Merrills thinks no one at Wesfarmers knows how to run a supermarket. In the meantime, the Wesfarmers price will be subject to fluctuations in the price of coal more so than it might be of milk and bread.

Put all that together, and…

Click to view our Glossary of Financial Terms