Thursday, December 13th, 2018
Our last article covered the prospects for Coles after its demerger from Wesfarmers. Today we explore the new, post-Coles Wesfarmers itself and define what will determine its share price.
We have long argued Wesfarmers should never have acquired Coles. The 2007 acquisition instantly halved return on equity by adding a large, capital-intensive business in a slow-growth, low-margin sector. The volatile, sub-scale coal assets further reduced the stock’s appeal and while we always had a price at which we would buy Wesfarmers, we were still reluctant.
The post-Coles, post-coal Wesfarmers is far more interesting. By exiting coal and majority ownership of Coles (15 per cent has been retained), Wesfarmers takes a strong step towards restoring its reputation as a trustworthy steward of investor capital. Bunnings, which has some of the best growth and returns – 30 per cent on capital compared with Coles at seven per cent – amongst large Australian retailers, now contributes nearly half of group earnings. Kmart has been turned around and is differentiated in the marketplace. Officeworks has performed surprisingly well in a very competitive market and has a credible online business capable of countering Amazon.
The new Wesfarmers also has a strong balance sheet ready to fund acquisitions with more growth than Coles. Wesfarmers could probably spend up to $10 billion on an acquisition(s) with reliable cashflows and this is likely to be in the chemicals and fertilisers sectors, where fundamentals can be volatile but returns are typically high.
So the question now is whether ASX investors have a new large-cap stock with more than GDP-style, low single-digit earnings per share growth (which Coles and the major banks offer) and if so, what that is worth. ASX investors are often starved of value in large companies with superior returns on equity, low gearing, strong free cashflow and self-funded high single-digit growth, as these stocks are typically expensive. If Wesfarmers could meet this description it would deserve a premium earnings multiple of 20 times or more in our view. So is the stock interesting at current prices, where the multiple is 17 times 2020 earnings?
The answer depends on how sensitive Bunnings sales are to the negative wealth effect from falling Sydney and Melbourne property prices and our outlook for consumers to deleverage over five to 10 years. Bunnings is now the main earnings and value driver for the group. Over the last 12 quarters Bunnings compounded annual like-for-like (LFL) sales at eight per cent, an excellent growth rate that reflected a lack of meaningful competition, strong brand equity, secular growth in the home, hardware and DIY categories, and new store openings. But LFL sales slowed to 4.9 per cent in the final quarter of fiscal 2018 from an average of 8.6 per cent over the previous three quarters. AGM commentary on Bunnings was subdued.
How much of this was caused by lower house prices versus cycling a very strong previous comparable period (4Q17), and resulting future trends, will determine much of the stock’s direction in the absence of M&A. We see a middle path for Bunnings sales during the house price downturn. Bullish forecasts for a return to high single-digit growth ignore the negative wealth effect on consumer spending apparent in the September quarter national accounts while bearish forecasts for a slowdown to three per cent ignore the expansion of Bunnings’ range and online penetration, and the DIY category’s resilient, defensive nature. This is one of Australia’s strongest retailers and it should continue to outperform the sector.
We expect average annual Bunnings LFL sales growth in line with the fourth quarter: around five per cent. New store openings should incrementally raise total sales growth above this.
Over the last year Wesfarmers divested businesses worth $2 billion and will reduce net debt by $1.7 billion after the demerger of Coles. In the absence of a material acquisition Wesfarmers could announce a fully franked return capital of capital (off-market buyback or special dividend) of 50 cents or more per share at the interim result. Not doing so could signal a large acquisition is imminent.
The departure of Coles and the reduction in debt create room to fund an acquisition in retail, where business values could be cheaper for longer while indebted consumers stay cautious, or in a variety of industrial sectors. Wesfarmers’ existing industrial businesses have received relatively little investor attention since Coles dominated the group but there could now be a range of M&A and/or organic growth opportunities in ammonia production/import, ammonium nitrate production and fertiliser manufacturing. Gas, an important input to these processes, has become more available in WA and domestic prices are falling. Wesfarmers might be able to increase scale in a gas-consuming sector and lock in long-term low prices, thus monetising the increased availability of gas.
Weighing profitability, growth and risk we value Wesfarmers at $33.60 per share. The share price of $31.86 at the time of writing implies a five per cent discount to value, which is not quite enough when sales growth at the largest business unit is slowing materially. Around $30.00 would be a better entry price.