EUR 850.00 For Business Accounts Only

Morningstar | Wesfarmers’ Bunnings Still Hungry for Growth. AUD 28 FVE Unchanged

Following the Bunnings investor briefing and site tour, we maintain our expectation the hardware retailer will outperform its competition longer term by executing on manifold growth options. But despite our positive outlook on Bunnings’ sales growth and profitability, shares in parent Wesfarmers are screening as significantly overvalued at our unchanged fair value estimate of AUD 28.00. Bunnings is Wesfarmers’ largest business segment, accounting for close to 60% of group EBIT, and the hardware retailer’s competitive advantages underpin our wide moat rating on the conglomerate.

We expect Bunnings’ growth to be underpinned by disrupting underpenetrated hardware categories, improving its share of trade sales--which hasn’t been the focal point in the past, and by continuing to expand its e-commerce capabilities and product range into new categories such as smarter home technology.

Each of these strategies bears risks, but on aggregate we expect Bunnings to succeed. For instance, as with other traditional retailers, the introduction of an online channel runs the risk of cannibalising brick-and-mortar sales and diluting profit margins. However, Bunnings’s online sales are virtually nil currently and are unlikely to meaningfully dilute EBIT margins of in-store sales in the medium term.

There are also transitory headwinds facing the business, including low wage growth and the weak housing market. The cyclical slow-down in the housing market is a negative for the hardware retail sector in general, but not necessarily for Bunnings. Although near-term sales growth and EBIT margins are likely to be adversely affected by prolonged housing weakness, the macroeconomic environment could force weaker players to exit the market, whose business Bunnings could then pick up.

Beyond expanding its range, adding stores to its warehouse network, and building an e-commerce channel, inorganic growth isn’t off the table for Bunnings. In our view, acquiring ASX-listed Reece Group could strengthen Wesfarmers’ wide economic moat and address two of Bunnings’ goals: bolstering market share in categories in which it is currently underpenetrated and grow its commercial business.

Bunnings is the undisputed leader of the Australian hardware market and is poised to further consolidate the market over the next decade. Over the next five years, we forecast Bunnings’ EBIT margins to average 12.2%, and sales to grow by 5.7%--ahead of the Australian hardware retailing market’s 4.5% growth rate.

Based on our definition of the Australian hardware retailing market, we estimate Bunnings’ market share at 38%, growing to close to 42% by fiscal 2028. Bunnings’ management estimates its market share at around 20%, but in defining the addressable market it includes categories outside of traditional hardware.

We don’t speculate on corporate action or include potential acquisitions in our base case valuation, but we identify Reece Group as an appealing target. Reece is a trade focussed hardware retailer and Australia’s leading supplier of plumbing and bathroom products. Its AUD 5.5 billion market capitalisation is within the reach of Wesfarmers’ solid balance sheet. However, there could be at least two stumbling blocks hindering this fictional transaction.

First, approval from Australia’s competition watchdog would be required. We estimate Reece’s share of the Australian market at 9% on our definition, and 5% on Bunnings’ definition of the addressable market. Second, following the AUD 1.9 billion acquisition of MORSCO in July 2018, about half of Reece’s AUD 4.8 billion sales are from the U.S. The overseas exposure could provide Bunnings with an avenue for overseas growth, but following the recent ill-fated expansion into the U.K. management and board might reconsider before entering new regions.

Bunnings estimates its market share in the flooring, window furnishings, kitchen, and bathroom categories at less than 10%--significantly less than in other categories. Also, management intends to materially increase its share of the trade market. Currently, about 30% of its sales are to commercial customers, compared with trade’s 40% share of the overall hardware market.

It is very early days for Bunnings’ online channel. It is lagging leading Australian retailers in other categories such as apparel or consumer electronics where online penetration generally ranges from 5%-10%. However, online sales of the Australian hardware sector are negligible and Bunnings hasn’t been missing out on sales growth due to its lack of an e-commerce channel. We suspect Amazon’s entry to the local market, the strong online sales growth of its U.S. hardware peers, and customers’ ongoing search for ever greater convenience, were catalysts for Bunnings to bring to life its own transactional website. After launching an e-commerce platform for special orders in February 2018, Bunning intends to introduce click-and-collect in Tasmania in April 2019, and then roll-out its online channel nationwide before the end of 2020.

Bunnings is expanding its offer into the world of smarter and safer homes, embracing a trend driven by technological innovation, as well as an ageing population and changing lifestyles. Smart products include security locks and cameras which connect to smart speakers, like Google Home Mini or Amazon’s Echo. Other categories Bunnings is expending into are commercial cleaning and auto-related products.