By Paul Rickard

It is unlikely that Managing Director Richard Goyder would have been that surprised by the market knocking 95c or 2.18% off the price of Wesfarmers’ shares yesterday, which saw them close at $42.63. The full year results, while solid overall, did highlight some ongoing issues with parts of the Wesfarmers conglomerate. Further, price deflation remains a key issue for the Coles supermarket business.

Wesfarmers net profit of $407m was down 83.3% on the 2015 result. After adjusting for non-cash impairments to the carrying value of the Curragh coal mine and Target department store business, the underlying profit after tax was $2,353m. This was down 3.1% on the FY15 result. Following a final dividend of 95c per share, full year dividends of $1.86 were down 7.0% on 2015. 

More worryingly, the second half was a lot weaker than the first half, and down on the same period last year. Second half underlying NPAT of $960m was down 9.8% on the $1,064m reported in the corresponding half in 2015.

Wesfarmers challenges emanate largely from two divisions. The resources division, which is mainly the Curragh coal mine in Queensland, suffered from the fall in coal prices, weather delays, foreign exchange hedging losses and lower than cost contracted prices to the Stanwell Power Station. Earnings declined from $50m in 2015 to an EBIT loss of $350m in FY 2016. The other business is of course Target (now part of the Department Stores division). Earnings declined to a loss $195m, or an underlying loss of $50m when restructuring costs and provisions of $145m are excluded, compared to EBIT of $90m in 2015.

EBIT by Division

The Coles supermarket business generated $1,860m or 52.6% of Group EBIT, while home improvement (mainly Bunnings) chipped in with 34.4%. The 2016 result included four months contribution from the recently acquired Homebase business in the UK. Homebase is being restructured and repositioned, and due to costs in connection with this, only contributed $1m in EBIT. While very early days, sales are up and Wesfarmers says the repositioning is going to plan. 

Kmart and Officeworks also performed strongly, the latter lifting EBIT by 13.6%.

Coles still leading in the sales war

Coles has most likely beaten Woolworths for the 28th consecutive quarter in the grocery sales war. Accompanying the full-year results were fourth quarter sales, which showed that when adjusted for the timing of Easter, comparable store sales in food and liquor grew by 3.3% in the quarter compared to the same quarter in 2015. The rate of growth was down from 4.4% in the third quarter. Woolworths should reports its fourth quarter figures today, which are expected to be flat to marginally positive.

Critically, Coles did highlight that deflation in food prices is increasing, which goes in part to explain why sales growth is stalling. In the fourth quarter, they estimated the impact to be worth 2.4% - up from 2.0% in the third quarter and an average of 1.2% in the first half. While there are also other factors at play, such as suppliers competing to provide goods at lower prices and the seasonal impact of fresh food, a major factor in price deflation is the supermarket chains - Coles, Woolworths, Aldi, IGA, Costco etc - competing aggressively to maintain market share.  

Sales at Kmart and Bunnings continued to grow strongly - the latter recorded growth in the fourth quarter on a same-stores basis of 8.3% compared with the corresponding quarter in 2015.

Same stores sales growth

*Adjusted for the timing of Easter

Where does Wesfarmers go from here? 

Wesfarmers has always been a big believer in the conglomerate model. Return on capital employed is a key business metric and divisions have to fight hard to win new investment capital. However, it is hard to see how divisions as disparate as retailing and resources, and so different in size, fit together or provide protection through the cycle.

There is no doubt that the resources division is impacting the market’s opinion of the underlying retail business. While there might be some extenuating circumstances at Curragh that impacted production, a fall in unit production costs of just 3.4% isn’t that impressive when compared to what the major miners have achieved this year.

And with Target, it seems that there is virtually no difference in market positioning between it and Kmart. When asked by an analyst to explain how the two department store brands were different, the answer given was that Kmart was “lowest prices”, while Target was “lower prices”. Further, Target was a “bit more feminine, and had more fashion”. 

Wesfarmers maintains that it can drive earnings improvement in Target by optimising the inventory range and applying Kmart’s process for direct sourcing, while maintaining two distinct brands. However, two Target stores have already been re-branded as Kmart, and two more are set for this in the next year. An obvious question then is - should Target just be wound into Kmart?

Bottom line

While the Wesfarmers conglomerate model is under pressure, a greater risk to earnings comes from the ongoing supermarket wars. Deflation remains a key concern, and if by some chance Woolworths can get its act together and grow its market share, EBIT from Coles, the mainstay of Wesfarmers, will be challenged.

Whatever happens, Wesfarmers profitability is not going to fall in a heap. But it is hard not to catergorise Wesfarmers as just a low-growth or even a no-growth business. The UK Homebase business might be the savior, but we won’t know this for some considerable time. With a dividend payout ratio of 89% of underlying earnings and free cash flow down, a further cut in dividends in FY17 cannot be ruled out.

Not a buy at these levels. Underweight this sector.