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Morningstar | Wesfarmers’ Long-Standing Department Store Star Dims Sooner Than Expected; AUD 30 FVE Unchanged. See Updated Analyst Note from 14 Jun 2019

Wide-moat Wesfarmers had bad news awaiting investors, just before kicking off its 2019 Strategy Day. The market wasn’t impressed, with the shares declining about 5%, but remaining overvalued. Severe competition in the department store sector is stifling sales growth at discounters Kmart and Target--together they represent Kmart Group. Price cutting and elevated promotional activity slashed their gross margins in the second half of fiscal 2019. In addition to structural headwinds, discretionary retailers have been struggling in a softening macroeconomic environment, although there could be some respite after the federal election, from recent and potential interest rate cuts and looming tax breaks.

We have lowered our estimated operating profit for the department store segment by 13% to AUD 554 million in fiscal 2019, in line with management’s guidance of AUD 515 million-AUD 565 million. The implied reduction of EBIT margins to 6.5%, is a year sooner than we expected. We have been forecasting that increased competition by newer companies, both traditional and online retailers, will curb sales growth. Coupled with the price transparency and fulfilment costs introduced by the rise in e-commerce, we expect this will result in lower midcycle operating margins. Our long-term EBIT margin estimate for the Kmart Group is unchanged at 6.0%, down from 7.3% in fiscal 2018. Hence, we maintain our fair value estimate of  AUD 30 per share .

Kmart is the department store that is most insulated from online threats and maintains its market share. However, we expect the chain will be forced to cut prices, at least in the medium term, as competitive pressures mount. Conversely, we forecast Target, and also Woolworth’s Big W discount department store, to lose market share and gradually shut stores as leases roll off over the next decade.

Our view differs from that of Kmart Group’s management, who see many industry participants struggling and the intense competition as unsustainable. However, we expect Amazon Australia to keep up pressure over the long-term as it continues to grab market share from most incumbent department stores.

At its strategy day, digital and data were the common themes across all Wesfarmers’ four operating segments. Bulking up digital sales capabilities and harvesting the vast amount of data on transactions that Wesfarmers collects, are key to understanding and meeting customer demands. We anticipate Wesfarmers to increasingly reallocate capital expenditures to its online platforms, away from physical stores. For example, Wesfarmers announced it made an agreement to buy online retailer Catch Group for AUD 230 million, subject to regulatory approval. The acquisition is immaterial to our fair value and earnings estimates, but brings more expertise in online retailing in-house. We project Catch Group to generate AUD 460 million in gross transaction value during fiscal 2020, contributing a mere AUD 14 million to Wesfarmers’ AUD 3 billion operating profit. Meanwhile, Bunnings is making headway with its own online platform. It has been testing a transactional website in Tasmania in 2019 and the platform is now ready to be rolled out across Australia by the end of the year--a year sooner than we had expected.

Also, the optimisation of its store networks in an omnichannel world was discussed--primarily relating to the department store chains. At Bunnings, there are still opportunities to open stores in new locations or infill-stores in catchment areas which are under-penetrated and where existing stores are overtrading. We expect Bunnings to continue gaining market share in under-penetrated categories such as bathrooms and kitchens. However, increasing the hardware retailer’s traction with trade customers is another large driver of growth. Currently, about 30% of its sales are to commercial customers, compared with trade’s 40% share of the overall hardware market.