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Morningstar | Wesfarmers Rallies Investors as Department Stores Surprise on the Upside; FVE Raised to AUD 39

Narrow-moat Wesfarmers posted fiscal 2018 underlying net profit after tax in line with our estimates. The results of its two key businesses, Bunnings and Coles--together accounting for two thirds of group operating profits--were broadly in line with our expectations. However, the department store segment, comprising only 15% of group EBIT, surprised with solid results well above our expectations. We interpret the segments’ results--EBIT margins are no longer reported separately--as Kmart sustaining its strong EBIT margins generated last year, and the weaker Target chain turning the corner in terms of its earnings earlier than we had expected, despite fierce competition from department stores, specialty stores, and growing online apparel sales.

We’ve increased our fair value estimate by 4% to AUD 39, due to increases to our earnings forecasts, slightly lower capital expenditures, and the time value of money. On average, we lifted EPS by 2% annually, mainly reflecting slightly higher EBIT margins in the department store and home improvement segments.

The conglomerate looks to have its ducks lined up. It has either divested or is in the process of divesting many of the businesses that were underperforming, exposed to significant structural headwinds, dependent on factors outside of management’s control such as price volatility, or simply noncore. The recent flurry of transactions leaves Wesfarmers post-Coles-demerger with a stable dominated by three retail businesses that we expect to grow strongly, take market share, and sustain relatively high EBIT margins--namely Bunnings, Kmart, and Officeworks.

These core businesses are a great platform to build on, either organically or through acquisitions, and the already robust balance sheet is set to become even stronger. The Curragh and Bengalla coal mines and Kmart Tyre and Auto Service transactions alone will provide AUD 1.9 billion in sale proceeds once all have been successfully closed.

We expect Wesfarmers to deleverage further by demerging Coles, ideally positioning management to pursue meaningful acquisitions or to return funds together with franking credits to shareholders.

Nevertheless, shares in Wesfarmers are priced to perfection and screen as significantly overvalued. In the medium term, a key risk remains Amazon Australia, which we anticipate becoming a more meaningful competitor of Wesfarmers’ discount department stores and stationery retailer, but less so in hardware. The global retail giant already operates two domestic fulfilment centres, and its core offerings, including Fulfilment By Amazon and Amazon Prime, are available to Australian retailers and consumers. Coles remains under pressure from rivals Woolworths and Aldi, and hypermarket Kaufland is poised to open its gates by fiscal 2020. We estimate that Coles lost 50 basis points of share in the Australian food and liquor market in fiscal 2018, ending up with around 27% of the market. Deflation lingered, and EBIT margins further contracted. Although we don’t envisage margins to deteriorate significantly from here, competition in food retailing is likely to be intense in the medium term, resulting in price-cutting and investments in service and convenience, in-store and online. We expect these factors to constrain margins at around current levels in the longer term.

For the combined group, including Coles, we forecast revenue and EPS growth to average 2.5% and 4.2%, respectively, over the next five years. At current prices, shares are trading at a P/E of 19 and a dividend yield of 4.6%. In fiscal 2018, revenue increased by 2.1%, while underlying net profit after tax declined by 3.5%. Dividends declared for the full year were steady at AUD 2.23 per share. Bunnings in Australia and New Zealand contributed AUD 1,504 million to group EBIT, in line with our AUD 1,501 million estimate. Like-for-like food sales at Coles continued to improve in the fourth quarter, and momentum has continued into the first quarter of fiscal 2019 on the back of the Little Shop campaign of collectible toys. Still, EBIT margins at Coles, including liquor and convenience, declined more than we had expected, by 30 basis points to 3.8%. Department store EBIT of AUD 660 million was 15% ahead of our estimate. Price-cutting drove double-digit growth in transactions at Kmart, and we estimate operating leverage more than offset lowering prices. Total sales at Target declined by 4.7% in fiscal 2018, in line with our forecast decline of 4.9%, but we estimate EBIT margins were some 100 basis points higher than our 1% forecast. Target’s gross margins were boosted by operational improvements in sourcing of merchandise, markdowns, sales mix, shrinkage, and store productivity.