Wesfarmers’ key retail businesses – Bunnings, Kmart, Target and Officeworks – are beginning to experience some retail fatigue. These businesses have enjoyed an extended period of super-sales throughout the COVID-19 pandemic, but sales are beginning to fade and this will continue over the next 18 months in our view. WES has acquisition capacity of up to $10 billion but has been reluctant to deploy it to any great extent so far.
WES generates 87% of group EBIT from retailing and therefore the prospects for long term sales growth and margins in its retail businesses are important to the share price. We think WES’s retail businesses will experience weaker earnings over FY22-23f given the elevated sales base during FY20-21f. The slowdown is a ‘reversion to normality’ effect rather than a weakness in the businesses. The factors behind this include industry volume growth, inflation and market share with volume growth likely to be most prominent.
Hardware sales have been significantly elevated over the last two years with growth of 10% and 11% contrasting with recent historical growth of 3%. Growth may continue in trade hardware as the building construction cycle lengthens given supply constraints. Housing construction particularly could be stronger in FY22-23f.
Department store sales fell in FY20 due to the impact of lockdowns but bounced back to 6% growth in FY21 as the country began to open up. Online growth was especially prominent. Growth in department store sales could exceed hardware over the next two years but this may reflect a recovery in lost sales.
While volume growth in various sectors may ease, pricing could remain nearer to 2% growth because of higher input and freight costs pressures.
Bunnings, Kmart and Officeworks are all the largest retailers in their respective categories. Each has scale benefits that accrue in sourcing inventory and lowering the cost of goods sold. There are scale benefits in operating online given the need for both IT and distribution infrastructure. WES retail businesses have grown market share through COVID-19 and should retain it as the economy re-opens.
We expect sales growth and EBIT margins to fade across FY22-23f from the peak levels enjoyed in FY20 and FY21.
WES has always approached its group business as a portfolio and has periodically bought and sold businesses. The most recent major divestment was Coles (4.9% remaining) but WES has made a new investment in the Mt Holland lithium project in WA and is also attempting to acquire API.
We estimate WES has up to $10 billion in acquisition capacity and there are many more opportunities available beyond lithium and healthcare. We do expect WES to focus on Australian opportunities rather than offshore, perhaps acutely aware its foray into the UK hardware sector ended badly for shareholders.
WES has said API would form the basis of a health division. In some offshore markets, pharmacies provide a broader range of health products and services, so WES may see API as a platform for that purpose. We think WES may need to raise its bid for API by 15-20% to be successful as API’s Board is of the view the timing reflects poorly on API’s profitability due to depressed COVID-19 earnings.
WES acquired Kidman Resources in 2019.This business held a 50% stake in a lithium mine in Western Australia. The operating entity is a joint venture with SQM of Chile (a large global lithium miner) and WES. The business will operate the Mt Holland lithium mine and process its output in Kwinana in WA to produce lithium hydroxide.
Lithium hydroxide is a key material used in the production of batteries for electric vehicles.
The mine has a resource of 189 million tonnes of lithium oxide with reserves estimated at 94mt. This gives a mine life of approximately 40-50 years though we note production could be doubled under the plan put forward by Covalent, the JV company.
Like any mining business, the earnings and value will depend heavily on the cost of production and the long-run price of lithium hydroxide.
The large retail businesses within the WES portfolio draw most of the attention, but the company owns an array of other assets and businesses that in aggregate are worth about $4 billion, in our view. These include the residual holding in Coles, a 24.8% stake in BWP Trust, a 50% interest in Gresham Partners (investment banking), a 50% interest in Wespine and a 50% stake in the FlyBuys customer loyalty program.
The company also owns almost $1 billion in property which is typically bought in order to develop a retail store and subsequently sold after securing a long term lease.
Investment view
WES is demonstrating great patience with regard to its acquisition strategy. With a demonstrably strong balance sheet, it has so far limited its deployment to adjacent businesses such as Adelaide Tools and the pending acquisition of Beaumont Tiles. As large as Bunnings already is with annual sales at $15 billion in FY20, the company has sized its total market at $94 billion across Australia and New Zealand. We estimate Bunnings is almost 50% of all retail hardware, but its share in other relevant retail areas is only 11% and trade at 7%.
The investments into lithium and healthcare (API possibly) are in new sectors but are of a scale that has not repeated the ‘Hail Mary’ acquisition of Coles back in 2007.
The 2019 acquisition of Catch Group has proven to be timely given the rapid expansion of online sales and fulfilment over the last two years. WES is investing heavily in Catch Group so its real value across the retail portfolio is difficult to judge while its earnings are suppressed. If compared to other online platforms such as Kogan and Amazon, Catch Group could currently be worth as much as $1.5 billion.
Despite the volatility of the economy over the last two years, WES is trading at an all-time high for both its PE ratio and its PE relative to the market.
Over the long term, WES has traded at a PE ratio closer to a 24% premium to the ASX200 but is presently at a 60% premium.
Based on our expectation that retail earnings for WES will soften over the next two years, we think the PE ratio of 30x fully values the company. We retain our Hold recommendation on the stock but remain wary of potential earnings weakness in the retail businesses.
