Wesfarmers’ earnings update signalled the toll that COVID-19 has taken on Kmart as sales have stuttered and costs have soared. The retail-centric WES continues to muscle up its group infrastructure for future online trading, but with rising supply chain costs weighing in, lower margins are likely to be entrenched for Kmart.
WES reported that the combined sales of Kmart and Target fell 10.3% in 1H22f while gross transaction value at online-only Catch grew 1.0% in the period. WES said almost 25% of store trading days had been lost for Kmart and Target due to forced store closures and although trading improved as restrictions eased, the rising number of COVID cases affected the Christmas trading period and the first two weeks of January 2022. These types of costs and imposts will be temporary, but Kmart is facing a more permanent rise in costs from the roll-off of favourable freight contracts and the need to build IT and supply chain infrastructure to support profitable online sales – currently at 14.3% of total sales for Kmart and 26.9% for Target.
The combined earnings before tax for Kmart and Target in 1H22 will be between $215-223 million. WES decided to keep paying team members who were impacted by COVID-19 either through isolation requirements or through reduced store work due to lockdowns. Rising international freight costs and higher costs due to elevated inventory holdings put further pressure on margins. Profitability and productivity were generally lower as reduced staff availability hampered operations.
WES noted that Bunnings and the Wesfarmers Chemical, Energy and Fertiliser businesses had performed well but Officeworks had been impacted by COVID-related disruptions and costs.
WES group net profit after tax for 1H22f is expected to be between $1,180-1,240 million, in-line with current consensus expectations.
Investment view
We already held the view that WES’ earnings would fall over the next two years and that the consensus PE ratio at 29x was too high. The earnings update provides evidence that this view may be correct with uncertainty from the duration of COVID-19 impacts, supply chain difficulties and execution risk from the increasing investment in online infrastructure.
WES is still seeking to acquire Australian Pharmaceutical Industries and there is press speculation the company is also looking at the Greencross business (pets and vets) currently owned by private equity. WES’ balance sheet is in excellent order so the financial risks are low, but there are some challenges confronting the company. We have retained our (soft) Hold recommendation.
