By Paul Rickard

Investor strategy days are designed to show off a company’s strengths and the capabilities of the management team. The hoped for outcome is that investors and analysts go away a little more comfortable, and in due course, consider whether an upgrade is warranted. You certainly don’t want the immediate reaction to be a “sell”.

Yesterday, Wesfarmers held its annual Strategy Briefing Day. The shares, in an otherwise quiet market, fell by 2.85% to close at $40.23. So by this measure, Wesfarmers failed the test.

And this sell down comes after Wesfarmers has been subject to downgrades from analysts and bearish comments from several experts. Writing in the Switzer Super Report two weeks ago, Charlie Aitken suggested that investors go “short” on Wesfarmers. While he is bearish on all Australian discretionary retailers and retail landlords, he cited these five specific reasons in relation to Wesfarmers:

  • He views Wesfarmers as a listed “private equity group”. Due to the unprecedented inflow of funds into private equity, Wesfarmers isn’t that big on a global scale and he argues that it will struggle to compete with the global private equity giants;
  • Secondly, long standing CEO Richard Goyder is leaving;
  • The competitive pressures from Amazon and others confronting all of Wesfarmers' consumer businesses - Coles, Target, Kmart, Officeworks and Bunnings. With Bunnings, he argues that it is “as good as it gets” right now with peak cycle earnings, as new home construction has peaked and house prices are starting to soften;
  • Concerns about Wesfarmers' acquisition of 500 Homebase stores in the UK and just how smoothly the re-branding will go; and
  • From a technical perspective, the share price looks “precarious”, with a move through the 50, 100 and 200 day moving averages now confirmed.   

Last week, Morgan Stanley downgraded its rating for Wesfarmers from equal-weight to under-weight, and slashed its price target from $41.00 to $36.00.

The “good” according to Wesfarmers

At the Strategy Day, Wesfarmers CEO Richard Goyder argued that Wesfarmers was in reasonable shape. He made these points to support his case:

  • The conglomerate model, and Wesfarmers' disciplined approach to capital allocation, has produced superior long-term returns for investors. He produced the chart below, which shows that over the 32-and-a-half years to May 2017, Wesfarmers has delivered a return to shareholders of 19.3% pa, outperforming the broader market (as measured by the All Ordinaries accumulation return of 10.8% pa) by a staggering 8.3% pa; 

 

 

  • There was a smooth transition in place for the senior leadership roles involving experienced, internal executives. Rob Scott is succeeding Richard Goyder as CEO, Anthony Gianotti is taking over from Terry Bowen as CFO;
  • The strength of Wesfarmers' balance sheet, with net capex of $1.1bn to $1.2bn in FY17 (mainly on new stores and store refurbishments); 
  • Interest costs are falling;
  • The plan to transform the 500 Homebase stores in the UK into the Bunnings warehouse format (but with key local elements) is making sound progress, with four pilot stores open by June 30; 
  • The investment in Coles to deliver a better customer offer (service and price) with ‘simplicity’, the enabler was necessary in the current environment, and was the right call for the long term; 
  • The “hardware” market (Bunnings) has evolved from traditional hardware to home improvement to now home improvement and outdoor living, and this gives Bunnings “lots of runway” to grow.

The “not so good”

Against these positives, Wesfarmers warned:

  • That the investment in the “customer offer” at Coles (lower prices) had increased noticeably in 3Q17 (March quarter) and 4Q17 (June quarter) relative to the second quarter. Wesfarmers reported that the “vast majority of the 1H17 underlying EBIT decline of $64m was attributable to the second quarter investment”;
  • Target is a basket case. Wesfarmers' timeline has another two years to “fix”, two years thereafter to “reset”, and “growth” from FY21;
  • Officeworks is experiencing ”variable trading conditions”; and
  • In the resources portfolio, Curragh’s export metallurgical coal sales in FY17 is expected to be at the lower end of guided range of 8.0 to 8.5mtpa, while the Stanwell (40% owned by Wesfarmers) export rebate obligations will be significantly higher in FY18 (due to lag effect from higher coal prices).

Unfortunately for Wesfarmers, the negatives outweigh the positives.

The Brokers

Prior to yesterday’s Strategy Day, the major brokers were largely negative on Wesfarmers with (according to FNArena) one buy, four neutrals and three sells. The consensus target price was $41.87.

The brokers had Wesfarmers trading on a multiple of 15.5 times FY17 earnings, but with almost negligible earnings growth forecast for FY18, a multiple of 15.3 times FY18 earnings. The forecast dividend yield was an attractive fully-franked 5.4% for FY17 and 5.5% for FY18.

Following the Strategy Day, there is a good chance that analysts will make small cuts to earnings forecasts, marginally increasing the earnings multiples and marginally reducing the forecast dividend yield. 

Bottom Line

Wesfarmers is trading on a much lower multiple than Woolworths (15.3 times for the former for FY18 vs 20.9 times for Woolworths). However, Woolworths is seen as a recovery stock, has the momentum in the sales war with Coles, and it is now a cleaner business. 

The problem for Wesfarmers is that, given the reaction to the Investor Strategy Day, they will now be challenged to provide any new information that may lead to an upgrade. If the August full-year profit result was going to be a cracker, there would have been a more definitive hint in the briefing. It sounds like that the result is not going to be a disaster, but probably a little soft.

So, while I still prefer Wesfarmers and am happy to back a proven track record, my sense is that the stock is going to wallow. Buyers have time on their side and can afford to be patient.