This week Guy Carson takes a deeper look at Wesfarmers (WES.ASX), where things just aren't as rosy as they seem.
A few weeks ago, shares in Fletcher Building shot higher on the back of speculation in the press that Wesfarmers (WES.ASX) was building a stake. On the back of the spike in the share price, Fletcher Building went into a trading halt and announced a rights issue. Whilst in the process of raising capital, Fletcher Building management confirmed that Wesfarmers had not in fact been buying their shares. Now, the cynic in me would suggest that someone close to the transaction had leaked false information in order to boost the price for the capital raising; however I would struggle to back this claim up with any evidence.
Fletcher Building has had some significant problems in recent times despite a record building boom in New Zealand and has been forced to cut its dividend and renegotiate their debt facilities. A number of analysts have suggested that the company would tick a lot of boxes on Wesfarmers, a dominant player in an industry that has come unstuck due to poor execution. However, whilst most of the investment community was focusing on the merits of the potential transaction, in our minds it raised a different question. That question is whether Wesfarmers the logical owner for New Zealand’s largest construction company and more broadly is it time to break up Australia’s largest conglomerate?
The history of Wesfarmers is quite unique within Australia. It began life back in 1914 as the Westralian Farmers Co‐operative Limited. In 1984, the company went public and one of its first big moves came in 1987 when it acquired a 10% stake in Bunnings. It would eventually move to full ownership of Bunnings in 1994. In 2003, the rural aspect of the business came to an end when the company sold Landmark to AWB.
Despite this long and impressive history, it is fair to say Wesfarmers’ recent track record has not been flash. If we look at the two major acquisitions that Wesfarmers has made since 2007, Coles and Homebase, neither have worked out as planned. The jewel in the crown, Bunnings, has in our opinion hidden a lot of the damage done.
We can start by looking at Coles, which Wesfarmers acquired for a valuation of over $21bn back in 2007. The acquisition was completed via scrip and cash with new shares issued at $45.73 (a price they haven’t seen since). Post the acquisition, Wesfarmers had to raise equity twice at significantly discounted levels in order to pay down debt and fund significant capital expenditure.
The company now plans to demerge it via an IPO and whilst unknown at this stage, most market indications are that the demerger price will not be significantly different from the acquisition price. The reason given for the divestment is the low return on capital from the asset; Coles takes up 61% of the group’s capital but accounts for just a 34% of their earnings. Whilst management are right to point this out, they only have themselves to blame. The major reason for the low return on capital from Coles is the purchase price which Wesfarmers paid.
Wesfarmers acquired a company that was underperforming and they thought they could turnaround. However, in order to get control they paid a premium. The total assets on the Coles balance sheet were $9,721m at the time of acquisition and yet they paid more than twice that. The result was an asset with a low return on the capital employed. Based on Wesfarmers calculations (which incorrectly uses EBIT instead of NPAT), the return on capital was a meagre 5.5% in financial year 2009.
Wesfarmers points to a 9.5% EBIT growth rate over its ownership as a measure of success but the reality is that the returns on capital of this division have disappointed. The company has spent a lot of capital on remodelling and expansion, due to this spend and disappointing sales in recent times, the return on capital for Coles has fallen from 11.2% in FY16 to 9.0% over the last 12 months. If we were to calculate an Internal Rate of Return for Wesfarmers’ investment in Coles, we believe it would fall well short of anything management would be happy with.
In addition to a poor return of Coles, the other assets acquired within that transaction have not performed well. Earnings from Officeworks have gone backwards during Wesfarmers ownership and the discount retailers (Kmart and Target) have both had their issues.
The Coles acquisition though cannot compare to the disaster that is Homebase. Wesfarmers purchased the company for $699m and has since deployed $219m in capital to the business. Despite the new capital, the earnings have gone backwards.
When they acquired Homebase, it had an operating profit of £26.3m on the back of £1,461.2m of sales. In the last financial year, Bunnings UK and Ireland delivered an EBIT loss of £54m on sales of £1,229m (down c. 16% from before the purchase). Wesfarmers have now been forced into taking an impairment of £454m or A$795m on the invested capital of A$918m. They have effectively written off 87% of the assets value on the balance sheet in less than 2 years. The company bought a barely profitable asset near the top of the cycle believing they could improve its operational performance.
Maybe the reason Wesfarmers thought they could turn around Homebase was the success they had had with Bunnings. Bunnings has hidden a lot of ills for Wesfarmers in recent years and has been the primary driver of earnings growth over the last decade. EBIT has grown from $659m in 2009 to over $1.4bn now. The returns on capital have also grown, most notably since 2013. In fact, the business has world leading margins and returns on capital for home improvement retailing. Interestingly, the recent lift in returns on capital happens to coincide with Australia’s largest ever residential building boom. Logic suggests that the area of home improvement will be highly correlated to this boom and we’d suggest that, if management were realistically looking to maximise shareholder value from their investments, they should be looking to sell Bunnings somewhere near the peak.
After divesting Coles, Wesfarmers will have a significant amount of capital to deploy into new acquisitions. The question is, should shareholders trust this company to spend it wisely? This is the company that quite clearly paid too much for Coles, leading to a substandard return and then managed to write-off 87% of the value of Homebase within two years. Despite the success of Bunnings, the share price still remains below the $45.73 level that Coles shareholders received back in 2007. Management appears to have no magic formula when it comes to acquisitions and if not for the 1994 purchase of Bunnings, we think a lot of other people would be questioning the existence of the conglomerate.
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