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Insights from the company monitor: Wesfarmers

By John Campbell ASA company monitor

To quote from Morningstar, Wesfarmers Limited (WES) is a diversified business operating supermarkets, department stores, home improvement and office supplies, resources, chemicals, energy and fertilisers, and industrials and safety products. WES is headquartered in Western Australia.  Conglomerates are unusual in the Australian business scene, and WES has been predominantly retail-focussed since 2007. It is classified as ‘food/staples retailing’ industry sector by the ASX.

Wesfarmers was incorporated in 1914 as the Westralian Farmers Ltd.  Between the world wars, Wesfarmers grew and acquired an interest in a fertiliser supplier.  In the 1970’s, WES acquired control of the much-expanded fertiliser business known as CSBP involving a fourfold expansion of its size.  It became a public listed company in November 1984 with a market capitalisation of $80m.  It continued to expand with the acquisition of coal mines, Bunnings, and Dalgety’s, then sold its Landmark rural business, which had incorporated Dalgety’s, in 2003. 

There have been a significant number of changes in key management personnel in recent times, particularly at the divisional level.  The chief executive for the period 1992 to 2005 was Michael Chaney, who took over the chairmanship last year.  Richard Goyder, who took over as CEO in 2005, will hand over that role to former Olympic gold-medallist rower Rob Scott after the 2017 AGM.  So effectively WES can be seen as being under new management.

A critical point in the history of WES occurred soon after Richard Goyder’s appointment, with the acquisition of the Coles group (Coles, Target, K-mart and Officeworks), which it completed in November 2007.  This coincided with the start of the GFC and WES was forced to raise a massive $4.6 billion in January 2009 in a placement and rights issue to repay bank finance used for the Coles acquisition.  Since Coles and the GFC, there have been no major acquisitions until 2016 when the group acquired a UK hardware chain, Homebase.

I commenced monitoring WES in 2010 and have continued to monitor the company since then apart from a break for the 2014 financial year – WES’ centenary year.  In 2010, there had been assertions in the press that WES had paid as much as $10 billion too much for the Coles group in late 2007, which had cost $19.5 billion.  It had succeeded in a cash and shares acquisition at an effective price of $17.25 a share whereas Coles Myer had turned down an offer from the private equity group KKR in 2006 of $15.25 per share.  After the 2009 results from its first full year of trading within the WES group, there were questions about the impairment of the $14 billion in goodwill carried in the group balance sheet.

WES had proudly asserted its ‘strength through diversity’ and that its acquisition policy was to ensure that it maintained its ROE at high levels, which in 2007 had been 25.1%.  This fell in 2008 to 8.5% with gearing at 47%.  With the Coles group earning a return on capital (ROC) of just 6.6% for 2009 compared to an ROC of 29.8% earned by pre-existing WES divisions, there was a degree of uncertainty about the extent of possible future write-downs of goodwill. 

  

WES recruited Ian McLeod in 2008 to take charge of Coles and turn its results around.  Financial constraints within the Coles group probably led to Coles supermarkets being under-resourced in terms of maintenance and appearance such that on acquisition by WES in 2007, it was run down and falling well behind Woolworths in customer appeal.

McLeod’s six-year term of office cost the group on average $10m/pa in reported remuneration but Coles’ overall EBIT contribution for the period since acquisition to 30 June 2016 was $11.6 billion as against about $23 billion invested in terms of initial acquisition cost and subsequent capex.  It will take quite a few more years of current profits for WES to achieve a full pay-back of capital invested in Coles. The question which is at the forefront of analysts’ minds is whether Coles and Woolworths can sustain their profitability in the face of increased competition from both new supermarket  operators such as Aldi and Costco, and from online stores such as Amazon.

Initially, WES was satisfied with Target results. In 2009 and 2010, Target contributed $357m and $381m respectively with ROC in double figures.  However, it has gone downhill since falling into a loss of $195m in 2016, with a small EBIT of $16m for the December 2016 half year.  By comparison, K-Mart’s EBIT contribution has improved from $109m in 2009 to $470m in 2016, at an ROC of 37.7%.  This is in stark contrast to Big-W’s performance – it contributed EBIT of $200m to Woolworths in 2009 but this had fallen to a loss of $15m in 2016.

So perhaps there are lessons to be learnt from K-Mart’s management and there is room to question the wisdom of Target’s chosen positioning of mid-market between the high price and quality of the Myer/David Jones stores and discount department stores such as K-Mart and Big-W.

Another issue facing the group is the attitude of investors and the Australian public to coal mining.  The view that it is possible to reverse climate change by eliminating the use of coal for power generation here and overseas is widespread.  It ignores the reliance of large populations on coal to provide electricity which is essential to the development of their economies as well as to their comfort and lifestyle.  It spreads to an almost religious perception that coal mining is ‘bad’ and ignores the need for coal as a raw material in steel production.  Over the years 2008 to 2016, WES’ resources division has contributed EBIT of $2.3 billion, more than fertiliser and chemical division and marginally less than K-Mart.  WES’ Curragh mine has more than 80 years’ of reserves and resources at nameplate production levels so to sacrifice coal for the sake of public opinion would be a significant blow to shareholders.

In 2016, WES acquired the Homebase chain of hardware stores in the UK and commenced trialling their conversion to Bunnings Warehouses.  The acquisition cost at $713m is modest and probably dwarfed by the future cost of converting the stores to Bunnings, but WES is approaching the task by trialling a few stores first before launching a full-scale conversion so as to limit the risk that the venture could imitate the Masters experience of Woolworths. 

The highlight of monitoring WES has to be its AGM.  WES has a strong parochial shareholder base with its AGM attended by 1300 people in November 2016.  In my experience WES is unusual in holding its AGM at 1pm.  Shareholders are provided with a weighty gift bag filled with brochures and small gifts such as packets of biscuits.  They are invited to inspect the company’s operations in an exhibition area full of demonstrations accompanied by members of the WA Symphony Orchestra playing beautiful music. The AGM is held in an adjoining auditorium but, with WES offering its shareholders alcoholic refreshments, the hubbub of noise from those enjoying the hospitality is quite noticeable by the time the formal business gets underway in the hall and almost drowns out question time when we get to it.  It is probably only ASA members who remain at this stage to hear my questions about remuneration and we are lucky to find any canapes left by the time the meeting ends.

This article was originally published in EQUITY Magazine, Sept 2017

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