Wesfarmers Ltd (WES) - BUY - Analyst Research

FY18 was a turning point for Wesfarmers (WES), after significant changes and repositioning of its portfolio, with the group’s proposed demerger of Coles (Nov 2018) and divestments of Curragh mining and Bunnings UK and Ireland (BUKI).

COMPANY DATA

Date of Report	ASX	Price	Price Target	Analyst Recommendation
16/08/18	WES	A$52.41	A$54.70	BUY

Date of Report

16/08/18

ASX

WES

Price

A$52.41

Price Target

A$54.70

Analyst Recommendation

BUY

Sector : Consumer Staples	52-Week Range: A$40.29 – 52.70
Industry: Food & Staples Retailing	Market Cap: A$59,447.2m

Source: Bloomberg

Company Description

INVESTMENT SUMMARY

We rate WES as a Buy for the following reasons:

Diversified asset base with core assets continuing to grow (Bunnings)
Expect improved performance from Target and Industrials businesses.
Disposal of struggling business BUKI and Curragh Mine, and FY19 disposal of KTAS, and partial disposal of Bengalla, reducing earnings volatility and strengthening balance sheet.
On-going focus on shareholder return including attractive yield.
Strong management team, new CEO likely to bring the same WES discipline (given he is an internal appointment) but his own style to the leadership of the company.
Strong balance provides flexibility to take advantage of opportunities as they arise.
Potential capital management initiatives.

We see the following key risks to our investment thesis:

Margin erosion due to competitive pressures.
Deterioration in balance sheet metrics.
Execution risk with Homebase in the UK.
Continual slide in performance of Bunnings UK and Ireland.
Deterioration in coal prices.
Adverse movements in AUD/USD.

Figure 1: WES Revenue by Segment

Source: Company

ANALYST’S NOTE

On a continuing operations basis, group underlying EBIT was up +4.5% and NPAT was up +5.2% on previous corresponding period (pcp). Whilst Bunnings ANZ (BANZ) reported another solid result (EBIT up +12.7%), it was the growth in Department stores’ EBIT (up +21.5%) that exceeded all expectations. The strong earnings growth appears to be driven by gross margin and cost of doing business improvements, although the former probably played a larger part, in our view.

Food and liquor revenues increased +1.6% over pcp with headline sales up +2.1% and comparables sales up +1.8%. These numbers suggest Coles had a much stronger second half. We expect sales growth to stabilize here and margins to improve. The group’s balance sheet remained strong, with strong cash generation and net debt declining -17.1% to $3.58bn. With WES’ business portfolio now largely streamlined, the question is where to from here?

With a strong balance sheet, investors are looking to management to see where they invest next. Given the experience of BUKI, we do expect management to be more cautious with their investment criteria. In the absence of a material investment opportunity, we expect shareholder returns to be on top of the priority list. Maintain Buy.

Coles appears to be making up ground on Woolworths. Total revenue of ~$39bn was broadly flat on FY17 (flat); EBIT declined -6.8% to $1.5bn, with EBIT margin of 3.8% dropping 30bps from pcp (4.1%). It was noted that the subdued earnings were due to the annualization investments made in the customer offer in the prior year, one-off profit on the sole of properties, and lower Convenience earnings. Food and liquor revenues increased +1.6% over the pcp with headline sales up +2.1% and comparables sales up +1.8%. These numbers suggest Coles had a much stronger second half. Deflation continued, at 1.8%, reflecting continual price pressures in a competitive market and seasonal factors, particularly in fresh produce (which accelerated in the fourth quarter).
Bunnings ANZ (BANZ) solid but moderating. BANZ had another solid year, with operating revenue up +8.9% to $12.5bn, and EBIT up +12.7% over the pcp. Although fourth quarter sales appear to have moderated and some may extrapolate this as a trend for the rest of FY19. Following the divestment of BUKI, earnings growth was furthered by a greater number of one-off costs relating to store closure provisioning, asset writedowns in the pcp. This divestment has also led to further investment into new stores and store refurbishment.
Department stores the standout. Total revenue for the segment was up +3.6% over the pcp, with earnings jumping +21.5% over the pcp. Detail was a little light on this front however, the market is likely going to question the sustainability of this growth including EBIT margin expansion of +110bps.

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WES FY18 RESULTS SUMMARY…

Figure 2: WES FY18 results summary

Source: Company

Coles earnings continue to slide, however stabilization in sight.Total revenue of ~$39bn was broadly flat with FY17 (flat); EBIT declined -6.8% to $1.5bn, with EBIT margin of 3.8%, dropping 30bps from pcp (4.1%). It was noted that the subdued earnings were due to the annualization investments made in the customer offer in the prior year, one-off profit on the sole of properties, and lower Convenience earnings. Food and liquor revenues increased +1.6% over the pcp with headline sales up +2.1%, while comparables sales up +1.8%. Deflation continued, at 1.8%, reflecting continual price pressures in a competitive market and seasonal factors, particularly in fresh produce (which accelerated in the fourth quarter).

Bunnings ANZ (BANZ). In May 2018, Wesfarmers entered an agreement to divest the assets of the previously struggling Bunnings UK & Ireland (BUKI) business for a nominal amount. BANZ on the other hand continued to perform strongly, with operating revenue up +8.9% to $12.5bn, and EBIT up +12.7% over the pcp. This strong performance can be attributed to solid execution of customer value investments, introduction of online transactional capacities, as well as further operating cost controls and favourable property divestments. Following the divestment of BUKI, earnings growth was furthered by a greater number of one-off costs relating to store closure provisioning, asset writedowns in the pcp. This divestment has also led to further investment into new stores and store refurbishment (predominately funded by WES’ property recycling program) – 10 net new trading locations and 13 stores under construction during the period.

Department store strength. Total revenue for the segment was up +3.6% over the pcp, with continuing growth strength in Kmart partially offset by ongoing troubles at Target. Earning jumped +21.5% over the pcp. Wesfarmers also announced the sale of Kmart Tyre & Auto (KTAS), with the sale to be completed in 1Q18 and to be recognized in FY19 and expects to record pre-tax profit on sale of between $270-275m. Management maintains that the Department Stores division is well positioned for the future.

Strong cash flows and strengthening balance sheet.Wesfarmers again reported strong operating cash flows for the half, although with a decline of 3.5% to ~$4.1bn, reflecting higher tax payments for earning from Resources and that which was paid in FY18. The neutral working capital result was indicative of increased net working capital investment in BANZ to support store network growth, as well as the AU/NZ Kmart brand acquisition and BUKI inventory clearance prior to its disposal. Net Capex of $1.2bn (up +17.6m on pcp) due to increase in BANZ store openings partially offset by lower capital spend on Coles. Balance sheet strengthened over the half, with net debt at $3.6bn (down from $741m over the pcp), reducing finance costs by -16.3% to $221m. Proceed from the sale of the Curragh mine was partially offset by cash retained from BUKI to support working capital requirements and financial obligations, leading to investing cash flows $424m lower than last year (includes proceeds on disposal of Coles credit card receivables of $947m).

Sale of Bengalla.On Aug 2018, Wesfarmers announced an agreement to sell 40% of its interest in Bengalla for $860m. The Group expects to record a pre-tax profit on sale of between $670-680m, further strengthening the balance sheet and reducing earnings volatility from the group’s profile.

Figure 3: WES Financial Summary

Source: BTIG, Company, Bloomberg

COMPANY DESCRIPTION

Wesfarmers Limited (WES) has diverse business operations covering supermarkets, liquor, hotels, convenience stores, home improvement, office supplies, and department stores. The company also has an industrials division which includes businesses in chemicals, energy and fertilizers, industrial and safety products and coal. Wesfarmers employs over 220,000 people.

Recommendation Rating Guide

Recommendation Rating Guide	Total Return Expectations on a 12-mth view
Speculative Buy	Greater than +30%
Buy	Greater than +10%
Neutral	Greater than 0%
Sell	Less than -10%

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Wesfarmers Ltd (WES) – BUY