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Morningstar | Wesfarmers’ FVE Drops to AUD 29 per Share and Its Moat Widens, as Coles Is Stripped

We upgrade Wesfarmers’ economic moat rating to wide from narrow following the demerger of the no-moat-rated Coles segment. Our wide moat rating is chiefly underpinned by the highly profitable and market-leading Bunnings hardware business, the key earnings contributor of Wesfarmers post-demerger.

We’ve updated our fair value estimate for Wesfarmers on a standalone basis to AUD 29.00 per share. Together with our AUD 13.30 per share fair value estimate for Coles, we value the combined entities at AUD 42.30 per share, implying an 8% upgrade to our previous intrinsic value of AUD 39.00 for Wesfarmers before the demerger.

The combined uplift in our DCF-based valuation is mainly due to: (1) applying a lower weighted cost of capital for Coles’ cash flows than as part of the Wesfarmers group; (2) lower estimated net capital expenditures; and (3) the time value of money.

We forecast Wesfarmers' five-year revenue CAGR at 3.4%, driven by strong sales growth from Bunnings at 6% over the period. The hardware division presents about half of the group operating profits from continuing operations, excluding Coles. We expect its dominance to rise over the next decade, accounting for 67% of Wesfarmers EBIT by 2028. Our fair value estimate equates to a P/E of 15, and an inflated dividend yield of 6.5% in fiscal 2019. The adjusted dividend yield from continuing operations is 5.5%, excluding the portion attributable to the first five months of earnings from Coles to Nov. 27, 2018.

We view Wesfarmers as a wide-moat company largely due to cost advantages from the significant scale, and the difficult-to-replicate store locations of its Bunnings hardware business in Australia and New Zealand. We estimate Bunnings has a market share of 35% in the Australian home improvement retail sector, with Metcash’s Independent Hardware Group, which includes Mitre 10 and Home Timber and Hardware banners, a distant second with 11% market share.

Bunnings has over 350 trading locations in Australia and New Zealand, which we estimate to generate revenue of AUD 13.5 billion and EBIT of AUD 1.6 billion in fiscal 2019.

Bunnings' scale generates significant bargaining power with suppliers when sourcing products, negotiating rents with landlords, and other areas. The chain passes along a large portion of these savings and operating efficiencies to its customers. Bunnings’ strategy has been to grow volumes over profit margins, broadening its range, investing in service and continuously cutting prices to grab market share and build a loyal customer base. This is reflected in the relatively muted EBIT margin expansion of 70 basis points to 12.0% over the past decade, despite revenue growth averaging 9% per year over the period.

Compared with other retail categories, large-format home improvement players have some defences against the encroachment of e-commerce and discount players, as the high weight/value ratio of many products prohibit cost-effective shipping and the specialised knowledge base employees offer is difficult to replicate. This strengthens our confidence about Bunnings' ability to generate ongoing economic profits ahead.

Bunnings’ moat is also sourced by the strength of its store network, an intangible asset, and is illustrated by the competing Masters hardware chain's failure to compete profitably. Following the closure of Masters, a joint venture of U.S. Lowe’s and Australia’s Woolworths, Bunnings' market position has further solidified. Masters' challenges in competing with Bunnings were partly due to its much smaller scale and lack of cost advantage, but also its inferior sites across most of its store network. For instance, Bunnings put its hand up to secure only up to 11 of the 63 Masters sites after its competitor ceased operations. Next to price and range, convenience is a driver of retail sales. Bunnings’ entrenched and far-flung store network in high-traffic corridors offers this convenience to consumers and this advantage is unlikely to be meaningfully disrupted by online competition in the foreseeable future.

Kmart is Australia's largest department store with sales of AUD 6 billion in fiscal 2018 and a market share of 34%. The next largest competitor would be Woolworths-owned Big W, which generated revenue of AUD 3.6 billion in fiscal 2018. Wesfarmers also owns the third-largest Australian discount department store, Target, although this brand is amid a multiyear turnaround attempt. The Australian Kmart and Target chains are unaffiliated to their respective U.S. namesakes. As the largest general merchandise retailer in Australia, Wesfarmers has a buying advantage over competitors, affording it a cost advantage. However, an economic moat is not warranted for the combined department store segment, given the high degree of commoditisation of products sold in this segment. Also, we forecast significant loss of market share to Amazon Australia from most players in the department store sector.

Officeworks is the dominant player in its segment and benefits from cost advantages due to its scale. Like Bunnings, Officeworks has been expanding its product range and consistently cutting prices, while investing costs savings from operating efficiencies in its in-store service and online platform. Over the past five years, sales increased by 7% on average, while operating margins expanded by 110 basis points to 7.3%. However, Officeworks’ “every channel” strategy also entails a strong focus on e-commerce and the office supplies chain operates a very successful omnichannel platform with online sales penetration of 20% versus the Australian retailing average of close to 10%. We ascribe a narrow economic moat to the Officeworks business.

We ascribe no moats to Wesfarmers' businesses in its industrials unit. Industrials includes chemicals and fertilisers, energy, and industrial safety, all of which produce commoditised products or are exposed to the resources cycle.

In summary, we believe Wesfarmers has a wide moat. With two thirds of its EBIT contribution from moaty businesses, we see ROIC remaining above WACC for the foreseeable future.