Retail therapy is working

The Board of Wesfarmers provided a cautious nod of confidence toward the future by lifting the final dividend at its full year result. As the non-food retail businesses put in the hard yards towards efficiency and better service, consumers are keeping retailers on tenterhooks on their propensity to spend. That is creating a fragile outlook for profits in 2011 in the retail businesses. There’s no such hesitancy in the resources division where quarterly coal pricing is setting this business up for another bumper year.

Turning to the charts, Wesfarmers found solid support around the $27.00 region, surging to a recent high of $32.28 on August 20. With any rally, a pullback is part of the process to allow buyers and sellers to reach equilibrium. We are currently in the corrective phase, which should see the uptrend line and both the 50 and 200 period moving averages around the $29 - $30 region offer solid support.

Wesfarmers believes it is well placed to benefit from any upturn in the Australian economy. At first glance this statement appears to have a lack of conviction. The company is wary of weak international markets and the potential second round effects of the GFC impacting on consumer spending in Australia. Fair enough. But the outlook statement goes on to express a confidence in the Australian retail businesses as further improvements are extracted from Coles, Kmart and Officeworks, even if trading in the first half of the 2011 financial year is challenging.

Conversely, the Resources division seems to be jumping out of its skin as quarterly coal price contracts are enabling significant increases in the export price of metallurgical coal, at least in the first quarter of this year.

The result

For the 2010 financial year, Wesfarmers reported a net profit after tax of $1,565 million, up 2.8% on the prior year. Operating earnings from the retail businesses increased 15.8% as the turnaround in Coles, Kmart and Officeworks continues. The home improvement business of Bunnings remains the standout with the best return on capital employed among the retail businesses at 30.4% compared to Coles at 6.5%.

Pleasingly for shareholders, Wesfarmers increased the final dividend by 10 cents to 70 cents per share, bringing the full year dividend to $1.25 per share. That represents a net yield of 4.4% and a payout ratio just above 90%. The dividend is fully franked and will be paid to shareholders on 30 September 2010. Wesfarmers operates a dividend reinvestment plan with no discount applied to the shares purchased under this scheme.

The increased level of operating cash flow to $3.3 billion has taken some of the pressure off the group’s capital expenditure requirements. This is particularly positive for the Coles supermarket chain, of course, as it enters the second phase of its turnaround strategy. This is a crucial time for Coles in that regard because it is now entering a period when the expenditure on renewal stores needs to be stepped up significantly. If Wesfarmers sustains the percentage of total capex allocated to Coles in FY11, then Coles will use up almost $1 billion of the total capex budget guided to between $2.2 billion and $2.4 billion for this year. In FY10, Coles spent $719 million of the $1.6 billion total capex budget.

Wesfarmers has been able to strengthen its balance sheet again this year with the issue of $500 million in domestic bonds and a further $755 million of European medium term notes. The proceeds of both were used to repay some shorter term debt. Gross debt for the group stood at $5.3 billion as at 30 June 2010 giving a gearing ratio of 13.1% on $24.6 billion of shareholders equity.

Black gold

After the extraordinary year in 2009 when coal prices soared to record highs, Wesfarmers’ resources division still enjoyed a very strong year albeit less spectacular. Operating earnings of $165 million paled next to FY09’s $885 million bonanza, but included an $85 million cost on the early close-out of a number of foreign exchange hedge contracts. The lag effect of the Stanwell Royalty also took some of the shine off but considering those factors, it was a good outcome.

Two major changes have occurred in this business. First, the shift to quarterly pricing contracts, in line with the majority of the coal industry, has changed the risk and reward profile of the business somewhat. Wesfarmers will certainly benefit from upward pressure on prices sooner than under the old annual contracts, but the same will apply in reverse. For now, prices are heading up as evidenced by the 70% increase in prices for the April to June 2010 quarter.

The second factor in this division is the expansion of the Curragh mine and the expected boost to annual production. Metallurgical coal exports will increase to 8.0-8.5 million tonnes per annum (mtpa) once the $286 million project is completed in the fourth quarter of CY11. In addition, the company is looking at the possibility of expanding Curragh even further towards 10mtpa from around FY14. Finally, the Bengalla mine is also nearing completion of a feasibility study for an expansion to 8.5mtpa with a target date of FY13.

Retail therapy

From basket case to rehab hero – that’s how some in the market will see the turnaround of Kmart so far. In truth, the progress to date, while exemplary, has been the sort of radical surgery the business needed just to survive. Now in post-op, Kmart is much slimmer with far fewer stock keeping units in each store, no more slow moving big ticket items (TVs, washing machines etc) and a vastly improved store layout and service culture. The next phase is to draw larger numbers of shoppers through the door and get them to buy more items each time they visit. Operating earnings of $190 million was a 74% increase on last year, but the profit margin of 4.7% is still too low.

Target’s operating profit of $381 million was 6.7% better than last year in a difficult and competitive environment. We think Target has been squeezed a little by the shift in Myer’s market position which overlaps many of Target’s categories. Target’s strategy has also shifted in the last year and is yet to prove itself.

Officeworks’ operating profit of $74 million was 13.8% better than last year as this group undergoes some of the tough love changes required to lift its performance. Under the wing of Bunnings’ boss John Gillam, we have confidence this can work over time.

At Bunnings, a 10.5% increase in EBIT to $728 million represented a 30.4% return on invested capital – another excellent outcome for this well-run business. Cash sales growth of 10.3% and a 10.8% lift in trade sales tells the story of a business doing everything right.

Coles update

The remedial work of the first phase is complete and Coles is now getting stuck into the mid-session of its five year turnaround plan. This will significantly upscale the rollout of the new store formats and extend the new stock replacement system (Easy Ordering) into all stores.

The new store format is now in 56 stores with another 100 expected to be refurbished this financial year. With 742 supermarkets on its books, there is substantial pressure on the group to accelerate this program. The results from the converted stores are good, as you would hope, so the benefits are there to be harvested as long as the execution is well handled.

The easy ordering system is now in 316 stores and the rollout will be completed by FY12. This not only greatly improves the working capital management in this business, but gives the individual store a big lift in appearance and productivity. Getting the supply chain equation right has been one of the principal aims of the turnaround project as it was this area that was severely hurting Coles’ performance.

The liquor and convenience stores are getting similar treatment on store renewal.

With better marketing, pricing, ranging and fresh produce categories, Coles is beginning to regain some lost ground. The 4.2% increase in total sales to just over $30 billion is encouraging, as is the 15.8% lift in EBIT to $962 million this year. There is still some distance to go before Wesfarmers will be happy with the return on capital given FY10 delivered just 6.5%.

From a longer-term perspective, support is located at the 39 week moving average (green line) at $30.00. Overhead resistance lies at the 200 week moving average (red line) at $31.50. Should a convincing break above this level result, we would expect a continued move higher towards the March 5 high of $33.21 over the longer term.

Summary

Considering the effects of the government stimulus payments in 2009 were quickly wearing off throughout FY10, the performance of the retail businesses was acceptable. More importantly, the effort into turning around the previously underperforming businesses has been steady but positive and we expect this to continue. In that sense, Wesfarmers still offers investors some further gains if the plans play out as the company hopes.

In the meantime, the Resources division is kicking goals as the high demand for all forms of coal looks sustainable. The expansion plans could lead to even greater value for shareholders.

Wesfarmers’ remaining divisions of insurance, chemicals and fertilisers, energy and industrial and safety all delivered acceptable results.

Wesfarmers will remain held in the Fat Prophets Portfolio.