Drew Meredith from Wattle Partners takes a look at Wesfarmers Ltd (ASX: WES), his latest “never sell stock”.
Wesfarmers is a diversified conglomerate with operations across retail department stores, home improvement, office supplies, resources, chemicals, energy and industrial products.
Primarily though, the company is a consumer-facing business due to its ownership of the dominant Bunnings and Officeworks chains.
Aggressive acquirer
We consider Wesfarmers as being one of Australia’s modern-day success stories, having acquired, built and sold a diverse array of businesses since its foundation in 1914. That said, the companies earnings are currently concentrated in its market-leading, monopolistic Bunnings franchise, which contributed $938 million of the $1.54 billion in earnings in 2019, or 60% of the total, followed by discount department store Kmart, $343 million and WesCEF (Chemicals, Energy and Fertilisers) at $422 million.
The company is an aggressive acquirer and it is this forward-looking nature that means Wesfarmers warrants a position within portfolios. The company deployed some $1 billion in 2019-20 through acquisitions of Kidman Resources, a lithium producer and Catch Group, an online, discount coupon retailer. This follows Wesfarmers’ sale of its thermal coal assets in 2019.
A proven ASX dividend share
Wesfarmers meets the requirements of the ‘Income Bucket’ due to its fully franked dividend yield of 5.4% and the relative consistency of both its dividends and free cash flow generation over the last decade.
The dividend was cut in 2019 following the successful demerger and sale of its investment in Coles Group Ltd (ASX: COL), which will benefit the company in the longer term by reducing the substantial working capital requirements in what is an ultra-competitive sector.
What the numbers say
Wesfarmers’ key business lines continued to delight shareholders in 2019 with strong sales growth across all, however, like-for-like EBIT margins contracted in all five segments due to a combination of reasons. These included wage inflation, payroll errors, digital investment, and product mix changes. As is the case with most consumer companies post COVID-19 comparable figures offer little insight into the future.
Management did, however, provide an update on its retail performance up to the end of May, reporting Bunnings had increased sales 19.2% and Officeworks 27.8% as investors flocked to both businesses as they prepared to work from home.
Target remains the only concern to shareholders, with management announcing a wide-ranging consolidation of their store network and a cost-cutting exercise in a bid stifle its poor performance. Management expect nearly half of Target stores to be closed or converted into the more successful Kmart model and are using the COVID-19 opportunity to renegotiate lease terms around Australia.
Why we like Wesfarmers shares
Wesfarmers provides investors with an excellent combination of monopolistic assets and growth opportunities. The market-leading return on capital delivered by Bunnings (52%) and Kmart (25%) affords management the flexibility to purse long-term acquisitions across any and all sectors of the market. It is this ability to be patient and extensive experience in both the mining and retailing sector that saw the company generate such strong returns from its significant bet on the turnaround of Coles Group.
We view the demerger of Coles as a positive for shareholders, as it frees up flexibility for less capital-intensive business opportunities in the faster-growing e-commerce and technology sectors.
It is becoming clear that the retail sector will look very different following the impending recession, with Wesfarmers’ conservative balance sheet offering the potential for a number of purchases.
Additional upside will come in the form of continued improvement of its existing businesses, with Bunnings only launching a full digital ordering offering in 2020, which we expect to add significantly to margins and sales.
The company is by no means cheap, trading at around 27x earnings, however, the business model is sound, gearing is conservative, and the company is well-led.
This report was written by Drew Meredith, Financial Adviser and Director of Wattle Partners. To get in contact with Drew, click here to visit the Wattle Partners website.
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