Article Wesfarmers under the pump as Coles loses momentum

Oct 31 2016 at 12:15
by Sue Mitchell
AFR
If Wesfarmers chief Richard Goyder wasn’t previously feeling pressure to offload the group’s coal assets he must be having second thoughts after the conglomerate’s weaker than expected first-quarter sales.
Wesfarmers was looking forward to a decent jump in earnings in 2017 after a horror year in 2016, when operating losses in Target and coal and $2.1 billion in asset impairments sent bottom line profits plunging 83 per cent and underlying earnings down 3.6 per cent.
Target was expected to at least break even this year after losing $50 million before interest and tax in 2016.
And after a 160 per cent surge in coking coal prices over the last three months, earnings from Wesfarmers’ Curragh and part-owned Bengalla mines were expected to rise to as much as $296 million compared with a loss of $310 million last year.
Expectations were high among Wesfarmers shareholders that Goyder would take advantage of the rebound in coal profits and sell the Curragh mine or the stake in Bengalla, removing a key source of earnings volatility and extricating Wesfarmers from what many believe is a sunset industry.
Analysts have now taken the knife to Wesfarmers’ full-year forecasts after softer than expected sales from four of its six retail businesses – Coles, Target, Bunnings and convenience – and a fall in coal production in the first quarter.
After a 22 per cent plunge in first-quarter sales, Target is now expected to lose as much as $20 million this year before returning to profit in 2018.
Forecasts for coal have been trimmed by between $50 million and $100 million after Goyder made it clear that previous estimates were too high, saying coal would just break even in the first half due to production issues and carryover volumes.
Investors believe Wesfarmers is still likely to sell the coal assets once it completes a strategic review which kicked off earlier this year. Other options under consideration, including expanding the Curragh mine into adjacent deposits, would require extra capital.
However, valuations for coal have been trimmed following Wesfarmers’ new guidance.
Morgan Stanley, for example, has cut its sum-of-the-parts valuation for the resources business from $2.2 billion to $900 million, valuing the business at just 3.7 times earnings before interest and tax rather than its previous multiple of 7.5 times EBIT. Citigroup believes coal is worth closer to $2.5 billion.
The range of valuations reflects uncertainty about the outlook for coal prices. While coking coal prices around $US90 a tonne were clearly unsustainable, few believe prices will stay as high as $US245 a tonne in the long term.
Goyder was giving little away about Wesfarmers’ plans for coal last week, saying it was unclear how long stronger prices would last and that the strategic review was ongoing.
In the meantime, every $US10 a tonne increase in the price of coal would add “tens of millions in earnings”, Goyder said.
“We’ve always said this was a valuable asset – high-quality metallurgical coal is a scarce resource. There have been encouraging signs recently that it’s not a flash in the pan and may last a little bit longer than we thought.”
A more pressing issue for Goyder is the outlook for Coles this year as competition intensifies in supermarkets and Woolworths finally starts gaining traction.
Coles is Wesfarmers’ single biggest business, accounting for 50 per cent of group earnings, but after years of double-digit gains, earnings growth has slowed and rose just 4.3 per cent to $1.86 billion in 2016.
Coles’ same-store sales rose 1.8 per cent in the September quarter, the lowest growth in seven years, and several brokers including Credit Suisse and UBS believe same-store sales growth will slow to 2 per cent this year – less than half the rate of growth over the last few years.
That’s barely enough to cover rising costs and could lead to operating deleverage unless Coles can find another pool of cost savings.
UBS and Citigroup now expect food and liquor earnings to fall between 1 and 2 per cent this year – the first decline in earnings since the Wesfarmers acquisition – as sales come back to the pack and margins come under pressure from price reductions.
The sudden reversal in Coles’ momentum has triggered a sell-off in Wesfarmers shares as investors contemplate the group’s changing fortunes.
Earlier this month the shares, buoyed by the surge in coal prices, came within reach of their high of $46.71.
By Friday, when Woolworths revealed it was closing the sales growth gap with Coles, Wesfarmers shares had fallen 13 per cent to a three-month low.
If Goyder was contemplating demerging Coles, as many investment bankers have urged him to do, he appears to have missed the moment.
The big question now for Goyder and Coles boss John Durkan​ is how Coles should respond.
Should it nip Woolworths’ recovery in the bud by cutting prices more aggressively, endangering margins?
Or should it do what Woolworths did a few years ago – raise prices and reduce staffing levels in stores to protect Coles’ and Wesfarmers’ profits?
Durkan has indicated his strategy will not change and Coles will continue to invest in a “sustainable” way – reducing everyday shelf prices to maintain its new-found trust with customers rather than emulating Woolworths by ploughing $1 billion into prices and service.
However, when push comes to shove, analysts believe Durkan will do whatever it takes to protect Coles’ market share.
One thing that Goyder has ruled out is diverting resources from other divisions to give Coles more resources to fight off a resurgent Woolworths.
“We do wrap our arms around businesses from time to time that need more care and attention. Target and Kmart are good examples and resources continues to gets lots of help,” Goyder told The Australian Financial Review. “But we’ll never cross-subsidise any of the businesses.”
That may be the case, but the rules are becoming blurred at Target and Kmart, which have been informally merged to create Wesfarmers’ new department stores division, overseen by Guy Russo.
Despite the quasi-merger, the two chains still compete for sales and customers, and Kmart’s gains in the latest quarter appear to have come at the expense of Target and Woolworths’ BIG W.
As UBS pointed out last week, while Kmart’s earnings have more than doubled over the last six years, the total profit pool in Australian department stores has not grown for five or six years.
For this reason, many analysts and investors have argued that Wesfarmers should sell either Kmart or Target – as one grows the other inevitably shrinks.
However, Goyder has made it clear many times in the past he sees more value in retaining both brands rather than selling one off to a competitor.
In any case, Wesfarmers would struggle to sell Target in its current condition. Morgan Stanley believes the business is now worth less than $1 billion, compared with more than $2 billion a few years ago.
Which brings us to Bunnings, widely considered the jewel in Wesfarmers’ crown.
Unlike Coles, Bunnings is still delivering strong growth, despite unfavourable weather in the September quarter and short-term disruption from Masters’ clearance sale.
On Morgan Stanley’s numbers, Bunnings is now worth about $19 billion, more than Coles’ food and liquor business, which is valued at $17.7 billion.
If Wesfarmers decided to take the advice of bankers and demerge or sell Bunnings it would undoubtedly be knocked over in the rush.
However, Wesfarmers would struggle to find new assets capable of generating returns as strong as Bunnings. The home improvement chain had a return on capital of almost 37 per cent last year.
Wesfarmers is more likely to continue to “recycle” Bunnings properties – a safer but far less exciting way of managing capital and boosting returns for shareholders.
Read more: http://www.afr.com/business/retail/wesfarmers-under-the-pump-as-coles-loses-momentum-20161028-gsdc6b#ixzz4ObHDZGPX