Wesfarmers at the crossroads

February 20, 2012
The Age

THE latest result from Wesfarmers, one of the last standing listed conglomerates, has raised some serious issues about the sustainability of a model that has produced profit growth of $55 million in the past six months after spending $5.5 billion on capital expenditure in the past 2½ years.

It is a disturbingly low return on invested capital that has prompted one of its biggest fans, Merrill Lynch analyst David Errington, to put the company on notice. Errington, who has had a ”buy” on the stock for 13 of the past 15 years, is questioning the returns given the size of the capex bill.

The rule of thumb is for every $1 invested in capital expenditure, a company should get 15 cents in increased earnings. This is far from the case with Wesfarmers. In the case of its coal business it has spent $1.64 billion in the past five years on capex yet its earnings have remained the same. In insurance, it has spent $1.5 billion in capex over five years, yet its earnings for the half were $17 million after being $70 million in the 2010 December half.

Put simply, a conglomerate’s reason for being is to play the numbers and play them well. Conglomerates have a number of different businesses operating in different parts of the cycle so that when one business falls victim to a downturn, the theory is the others can act as a buffer. But the theory falls down when the conglomerate picks the wrong industry, doesn’t have the right management to run the businesses or fails to keep recycling the portfolio so it can buy into one or two undervalued assets.

In Wesfarmers’ case it and its chief executive Richard Goyder – who has been in the top job for almost six years – paid too much for retailing giant Coles just before the global financial crisis.

It could be argued that its coal business should have been sold at the peak and its insurance business cut loose years ago instead of spending money on some mid-sized acquisitions.

Conglomerates have long been out of fashion because they are difficult to understand. The few that survived the portfolios of fund managers needed to provide consistently strong earnings growth, high dividend yields and a high return on equity.

The latest results for Wesfarmers show a pattern of unsatisfactory earnings growth, a substandard return on equity and middling dividend yields. In 2010, Wesfarmers ROE was 6.4 per cent, in 2011 it was 7.7 per cent and on Deutsche Bank’s numbers it will take until 2014 to reach an ROE of 10 per cent.

Not surprisingly a number of investment banks are believed to be busy working behind the scenes trying to find ways to help the company fix the situation. At a recent bank meeting a suggestion was raised to spin off Wesfarmers’ highly successful hardware business Bunnings and do an in specie (share) distribution, as a means of adding value to the share price. Another Sydney fund manager suggested splitting the company into two. Others outline several other ways to rev up the share price. These include: the divestment of Target or Kmart, the sale of its insurance division, the sale of coal, and the purchase of one of the many underperforming businesses listed on the ASX.

Wesfarmers is also believed to be examining the senior management of some of its underperforming businesses.

Wesfarmers has a number of businesses in its portfolio including Coles, Target, Kmart, Bunnings, insurance, resources, industrial and safety and chemicals, fertiliser and energy. Four of the nine reported an EBIT that went backwards or was flat in the six months to December 31.

Bunnings has been a consistently stellar performer, run by the highly regarded John Gillam, with EBIT up 6.1 per cent despite the downturn in consumer confidence and spending.

In the case of the Wesfarmers insurance division, it has produced disappointing results for a good deal of the past decade.
Insurance is now going through a tough cycle as reinsurance costs explode and the number of natural catastrophes produced the worst set of conditions in the sector for 40 years. Insurance is a business not for the faint-hearted. Wesfarmers needed to make a decision a few years ago to get much bigger or get out. It chose the middle road, spending up on acquisitions, and is now in no-man’s land.

In its coal business, the results have been less than flash. Coal is struggling in part because of last year’s floods, but it doesn’t fully explain its poor return on invested capital. The resources business produced a flat EBIT of $250 million for the six months.

In the case of Target and Kmart the company needs to decide whether it would be best to keep one and sell the other. Target suffered a 9.7 per cent decline in EBIT, while Kmart was up 12.6 per cent. In the case of Coles, which accounts for half of the company’s capital but produces just 33 per cent of earnings, it lifted EBIT 14.1 per cent. Nevertheless, it is still operating well below its cost of capital. While it has done a great job with its recovery, it is coming off a low base and still has a long way to go.

Wesfarmers is in an advantageous position because it generates a lot of cash and has a smorgasbord of options available to it to buy into or sell out of. Its corporate objective is to ”provide a satisfactory return to shareholders”. It needs to start doing it or someone will do it for it.

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