Public

Wesfarmers (WES) 2016 AGM Voting Intentions

Company/ASX Code : Wesfarmers Limited (WES)
Registry : Computershare Services
Poll/Show of Hands : Poll on all items
Webcast : Yes
Venue :
1pm Perth Convention & Exhibition Centre
Mounts Bay Road
Perth, Western Australia
Monitor : Mr John Campbell
AGM Details / NoM : Thursday 10th November, 2016

This company is monitored by John Campbell, assisted by Keith Mellis. The monitors had a pre-AGM meeting with Chairman Michael Chaney and Chairman of the Remuneration Committee Wayne Osborn. 

ASA Position
Not Applicable
Item 1: Consideration of accounts and reports

Financial performance

The two largest segments of Wesfarmers, Coles and Bunnings, performed strongly but their results were offset by poor results from the resources (coal) division and by Target stores.  Overall, segments other than Resources and Target contributed 8.4% ($311m) more EBIT than in 2015, but the two delinquents took EBIT down by $505m to $3,462 (2015: $3,759).  The two delinquents also contributed a $2,116m impairment charge (2015: nil), and Wesfarmers’ NPAT was a miserable $407m compared to $2,440 in 2015.

Despite lower product prices, Coles traded well increasing revenue by $1,041m to $39 billion, maintaining its EBIT margin and increasing its return on capital from 11.0% to 11.2%, whilst Home Improvements increased revenue by more than $2 billion to $11.6 billion, on a reduced EBIT margin (10.5% compared to 2015 – 11.4%) whilst also improving its return on capital.  Its results include the newly-acquired Homebase UK operations from March 2016 but its contribution is stated to be insignificant with an annual revenue level of $1.9 billion.  However, Homebase was responsible for the reduction EBIT margin referred to above.

Key events

As mentioned above, the Group acquired the UK-based Home Retail Group plc (‘Homebase’) for $665m in late February 2016, giving rise to $935m in goodwill provisionally.  The group is taking a cautious approach to converting Homebase to Bunnings, intending to trial a number of Bunnings-style stores before committing to large scale expansion of Homebase and at the same time reorganising products and supply logistics.  It will take several years to determine the success of the UK Bunnings trial.

The group’s main operating divisions have been re-organised into Coles, Home Improvements, Department Stores and Industrial during 2015/6.  This will group Target with K-Mart.  K-Mart’s success in recent years, improving its return on capital to over 30% and its EBIT margin to 9.1% in 2016, may well be contributing to Target’s decline (ASA’s observation not reflected in the Annual Report!), so better coordinated management may be the solution to its decline.  Resources will benefit from improved coal export prices in recent months provided they hold past contract renewal dates.  

Perhaps the biggest challenge for Wesfarmers is to manage changes to Coles and K-Mart/Target resulting from increasing competition from new entrants such as Aldi and from disrupters in the form of online stores.  ASA is also concerned that dividends have exceeded free cash flow in four of the last 6 financial years by $370m in aggregate.  Our concern is that high levels of distribution may not be sustained but we are reassured that Wesfarmers’ strong balance sheet, with gearing at 31%, ensures that cash flow is not a risk to future dividends.

Key Board or senior management changes

Michael Chaney succeeded Bob Every as chairman after the 2015 AGM.  There were no other board changes during the year.  The executive KMP group has also shrunk after Stuart Machin left following the Target supplier discount reporting issue, and Stewart Butel retired from being CEO Resources.  Resources has merged into the Industrial segment now headed by Rob Scott who is charged with turning around results in the Industrial & Safety division as part of that segment.  Terry Bowen remains Finance Director/CFO, and John Durkan and John Gillam remain chief executives of Coles and Home Improvement respectively.

Summary


ASA Position
For
Item 2(a): Re-election of Mr Tony Howarth as a Director

Mr Howarth has been a director for 9 years and is appropriately qualified. He is the former Managing Director of Challenge Bank. He is the Chairman of MMA Offshore and a director of BWP Management Limited (the responsible entity of BWP Trust). 

Mr Howarth is the Chairman of the Audit and Risk Committee. As Mr Howarth has now served for 9 years, this term of office will take him past 12 years, when the ASA will no longer classify him to be an independent non-executive director but we note that currently there are 7 independents vs 3 non-independent directors so it is likely that a majority of independent directors will still exist.  

He exceeds the ASA guideline of having at least 1 year’s fees in WES shares.


ASA Position
For
Item 2(b): Re-election of Mr Wayne Osborn as a Director

Mr Osborn has been a director since 2010 and is appropriately qualified. Mr Osborn chairs the Remuneration Committee. 

Mr Osborn is the former Managing Director of Alcoa and is currently a director of South32.

He exceeds the ASA guideline of having at least 1 year’s fees in WES shares.


ASA Position
For
Item 2(c): Re-election of Ms Vanessa Wallace as a Director

Ms Wallace has been a director for 6 years and is appropriately qualified. She is an international strategy consultant and is currently a director of AMP.

She exceeds the ASA guideline of having at least 1 year’s fees in WES shares.


ASA Position
For
Item 2(d): Re-election of Ms Jennifer Westacott as a Director

Ms Westacott has been a director for 3 years and is appropriately qualified. She is the CEO of the Business Council of Australia and is a former KPMG partner. She also sits on a number of advisory boards and councils.

While Ms Westacott’s holding in WES shares falls short of ASA’s guideline of having at least 1 year’s fees in WES shares, Wesfarmers’ policy is that non-executive directors should hold a year’s remuneration in shares after 5 years in office so she has some time to make good the ‘skin in the game’ target.


ASA Position
Against
Item 3: Adoption of Remuneration Report

The WES remuneration report is one of the most readable and readily understandable reports these monitors have seen.  The features of the WES remuneration structure generally comply with ASA guidelines:

•    4 year performance appraisal period for the long-term incentive (LTI), 

•    2 robust relative hurdles for the LTI - ROE and TSR (note: this will change for 2017), 

•    Short-term incentives (STI) measurement based in part on NPAT, in part on divisional EBIT, and not on ‘underlying earnings’

•    Allocation of share-based payments rights calculated on the market value of WES shares and not discounted, 

•    No dividend rights until shares are vested.  

The level of base salaries is still high.  Group Managing Director Richard Goyder’s fixed salary at $3.6m has been frozen since 2011 so is no longer so exceptional given his tenure of office since 2005. Finance Director Terry Bowen’s fixed element is close to $2m and the other divisional heads range down from slightly more than that to $1m.  However, given Wesfarmers’ status in the top ten Australian companies and the largest private sector employer, we do not view salary levels as excessive.

Accounting standards apportion the fair value of share-based payments over the period during which they are earned.  Measured on that basis, total disclosed remuneration was about 199% (2015:270%) of fixed pay.  Significantly, at-risk pay was much reduced in 2016 as the MD and FD both failed to meet the threshold for short-term incentives based on financial hurdles due to the impairment charges as well as the impacts on the long term incentive; no LTI rights vested in 2016 because the TSR and ROE hurdles were not met for the 2012 long-term incentive plan.

STI and LTI are individually less than fixed pay in most instances and a high proportion of STI is share-based.  During 2016, the board used its discretion to increase the target for the annual incentive for executives other than the group managing director from 60% of annual salary to 100% of salary on account of increased responsibilities being undertaken by them.  The ASA does not support the use of discretion to increase incentive pay especially in years where shareholders are penalised by poor results.  Whilst we accept the need for such parameters to be revised for changes in level of responsibility and similar factors, we think this should be done prospectively and not part way through a financial year.  

The ASA is also concerned that both MD and FD still earned in excess of $1m in cash STI even though they failed to achieve the threshold for the financial hurdles involving NPAT and ROE on which 60% of the MD’s STI and 50% of the FD’s STI were based.  We see their other hurdles involving diversity, talent management and safety as essentially soft hurdles.  However, Wesfarmers adopts the ASA-preferred method of determining financial hurdles based on profits determined using accounting standards rather than the method adopted by many companies of using ‘underlying’ profit excluding impairments and similar items.  The effect of using IFRS-based profit hurdles is that in 2016 the MD and FD did not earn any element of STI based on profits despite good underlying results.  Perhaps it is in compensation for this tough approach that some larger element of the STI is based on soft hurdles.

A further area of concern is the extent to which remuneration of executives is skewed to short-term benefits, ie salary and annual incentive.  The remuneration report states that remuneration arrangements are designed to encourage executives to behave like long-term owners, with remuneration providing a link to sustainable performance and satisfactory shareholder returns.  We think this should emphasise long-term incentives ahead of short-term ones but the combination of high fixed salaries and target 100% (MD) and 60% (other executives) annual incentive, compared to target 100% (MD) and 80% (other executives) for LTI, results in very generous incomes even if no LTIs are vested.  This is particularly the case for the group MD whose total remuneration ignoring LTIs exceeded $5.5m in 2016.

Our other concerns with WES remuneration structure are relatively minor:

•    we would like to see disclosure of ‘actual’ take-home pay, 

•    we prefer to see a compulsory holding lock over a proportion of shares for a period after vesting, and

•    we believe that LTI incentives should not be awarded if TSR has been negative, even if WES’ relative performance to other companies would permit an award.

We admit that there is a fine line in our assessment of remuneration reports between those we support and those we vote against.  We found it difficult to decide whether to continue the support we have given Wesfarmers’ remuneration reports in recent years or to vote against it and we have decided to vote against mainly because of the discretionary allocation of additional short-term incentive to executives in 2016.


ASA Position
For
Items 4&5: Equity grants to Group Managing Director and Finance Director

The performance rights proposed to be granted are for the long-term incentive plan under which Mr Goyder and Mr Bowen may receive up to 100% of their fixed pay based upon the extent to which the 4-year performance hurdle is achieved. The number of share rights allocated is calculated by dividing fixed pay by the average market price of WES shares over the 10-day period immediately following the full-year results announcement in August/September.  Although we have decided to vote against the remuneration report under item 3, we support many aspects of WES’ remuneration arrangements.  Therefore we intend to vote proxies in favour of the grant of these share rights.

The performance hurdles are normally a combination of relative TSR against the ASX50 companies and the relative compound annual growth rate of return on equity vs the same index. The impairments in 2016 to Target goodwill and Resources asset values totalling $2,116m cause the 2016 NPAT to be set at an artificially low level by comparison with what is expected to be achieved in future years and would facilitate achievement of the compound CAGR hurdle.  So the 2017 LTI will be determined solely on the basis of Wesfarmers’ TSR performance relative to the ASX50 companies over the 4 years to 2020.



The individuals (or their associates) involved in the preparation of this voting intention have a shareholding in this company. 


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