New Wesfarmers boss Rob Scott has a big job in front of him. Yesterday, Wesfarmers released its first half profit results, which showed that Group EBIT (excluding significant items) fell by 3.3% to $2.35bn and NPAT (excluding significant items) by 2.7% to $1.54bn. The star performer was the local Bunnings Warehouse business, which grew EBIT by 12.2% to $864m and topped (for the first time) the Wesfarmers divisional league table. It also reported comparable store sales growth for the second quarter of 7.5%.

At the other end of the league table was Bunnings United Kingdom and Ireland. Less than two years after acquiring the Homebase stores franchise and attempting to “bunningise” the UK, Wesfarmers has written off the whole investment of $777m, booked an inventory write-down of a further $66m, and set up a provision of $70m for store closures. To add salt to the wounds, the division reported an operating loss for the half of $165m.

Such are the challenges of running Australia’s largest conglomerate. One division firing, another in the doldrums.

And that was the common theme. Strong performances from Officeworks, Kmart and Resources, were offset by weaker earnings from the all-powerful Coles supermarket division, Target, Fertilisers and Industrial & Safety.

The following table shows high level segment performance. Due to the ongoing supermarket war and lower fuel volumes in convenience stores, earnings from Coles fell by 14.1% to $790m. Highlighting the competitive environment, the net margin fell from 4.6% of sales to 4.0% during the half year. On the other hand, the resources division benefitted from higher coal prices and stronger production, with EBIT increasing 51.4% to $209m.

Divisional EBIT

 

Encouragingly, Coles reported second quarter comparable store sales growth of 1.3%, up from the 0.3% in the first quarter and better than most analysts had forecast. This is still likely to be smashed by competitor Woolworths, who reported growth of 4.9% in the first quarter and are due to report their second quarter sales figures tomorrow. Coles also reported transaction growth, units per basket growth and customer satisfaction improvements.

Comparable Store Sales Growth

                       

While noting the momentum with the supermarket business, Management said that it expects price deflation to remain at elevated levels and divisional earnings in the second half will be affected by increased staff costs and lower earnings from the convenience stores.

Problem child Target continued its horror run, with sales falling by 6.5% compared to the corresponding quarter 12 months earlier. Wesfarmers didn’t disclose Target’s loss for the period, but said that trading margins had improved, it is working hard to reduce costs and the re-set of product, price and range continues.

For shareholders, Wesfarmers maintained its interim dividend of $1.03 (fully franked) per share. Cash generation was strong due to improvements in operating cash flow and working capital inflow, allowing Wesfarmers to increase net capital expenditure while reducing net debt by $0.4bn to $3.9bn. Wesfarmers will also neutralize its dividend re-investment plan by buying back on market the shares it issues.

WHAT THE BROKERS SAY

Going into the result, the major brokers saw Wesfarmers as fully valued and were not that positive on the stock. According to FN Arena, of the 8 major brokers that analyze the stock, there was only 1 buy recommendation (from Macquarie). There were 4 neutral recommendations and 3 sell recommendations., with a consensus target price of $40.20 (a 4.3% discount to yesterday’s closing price).

Of the two brokers who had published their analysis of the result (Citi and UBS), both saw it as marginally positive. While neither broker changed their target price, the UBS analysts said that they expected to see “modest upgrades to consensus forecasts post the release.”    

Broker Recommendations*

 

BUY OR SELL

Wesfarmers shares have traded in a very tight range over the last 12 months, from a high of $45.60 to a low of $39.52. Following a rise yesterday of 3.0% to $41.99, it currently sits mid- range.  

 

Wesfarmers (WES) – Feb17 – Feb18 (source CommSec)

Whilst there are some encouraging signs in the result (sales momentum with Coles, the power of the Australasian Bunnings business and strengthened balance sheet), the ongoing supermarket war between Woolworths, IGA, Aldi, Coles, Costco and potentially others will pressure Coles earnings. Target remains a challenge, and losses will continue from Bunnings UK. The outlook for the broader industrials division (which includes resources) is mixed.

The dividend yield is attractive, meaning that income investors will provide a solid level of support if the stock is marked down. Assuming it can maintain a second half dividend of $1.20 per share, Wesfarmers is yielding 5.31% pa fully franked. Grossed up, this is 7.44% pa.

For the time being, I can’t see Wesfarmers breaking the trading range. Buy in the high thirties, sell in the mid forties.