It might come as a bit of a surprise that the best performing sector in the Australian share market in the March quarter was consumer discretionary. It added 11.4% compared to the market’s overall gain of 3.4%.
The “surprise” is that almost every broker analyst, media commentator and so-called investment expert has been warning about the impact of higher interest rates and cost of living pressures on consumer confidence, and the inevitable slowdown in discretionary spending as consumers tighten their belts. The reality is that with the employment market so strong, there is little evidence to suggest that spending has really slowed. Hence, the market realised that this sector had been oversold and the strong rally in the March quarter.
The largest company in the sector is the conglomerate Wesfarmers (WES). It has risen from $45.91 at the start of the year to $51.65 on Friday, and paid a dividend of 88 cents per share. Overall, a return of close to 15%.
Conglomerates have largely disappeared from the Australian market thanks to demergers and market pressure for specialisation and focus. The clear exception is Wesfarmers. Washington H Soul Pattinson (SOL) is another, although it tends to act more like a fund manager and take (large) strategic stakes rather than exercising management control.
The Wesfarmers model is relatively straightforward: find a business that can generate a capital return beyond a hurdle rate and has reasonable tailwinds, invest in it, put the right management team in place to manage it and then let them get on with the job. It supports the business with a very ‘light touch’ head office.
The variety of businesses that Wesfarmers has is vast: from online retailing through to the production of ammonia and distribution of fertilisers. At its core however, it is a retailer.
Bunnings is the biggest division, generating $1.28bn of EBIT in the first half of FY23 (1H23) out of a company total of $2.16bn – almost 60%. The Kmart division, which also includes the troubled Target store network, brought in $475m – another 22%. Add in $85m from Officeworks, and that’s 85% from servicing consumers and small businesses through Bunnings, Kmart and Officeworks.
The Chemicals, Energy and Fertiliser division, which produces and distributes ammonia and other chemicals, imports and distributes fertiliser and produces and distributes LPG through Kleenheat, contributed $324m in EBIT. The new Health division, which follows Wesfarmers takeover of API and is involved in pharmacy distribution and is the owner of Priceline branded pharmacies, brought in $27m of EBIT. The Industrial and Safety division (Blackwoods, Work Wear) earned $47m.
Offsetting these contributions, the online retailer Catch, which Bunnings bought a few years’ back, lost $108m in the half year, widening from a loss of $44m in 1H22. Wesfarmers blamed ‘poor performance of the in-stock range and moderation of marketplace growth’ as online customers returned to shopping in physical stores, plus higher fulfilment and delivery costs. Wesfarmers has implemented management changes, with greater focus on cost control and inventory management. Losses are expected in the second half, but at a lower level than the first half.
One of the upsides for Wesfarmers is its investment in lithium. It has a joint venture with SQM called Covalent Lithium, which will mine lithium at Mt Holland in WA (near the goldfields in Kalgoorlie), crush and concentrate it, and then transport it to a refinery at Kwinana where the concentrate will be refined into battery grade lithium hydroxide.
The hard rock mine at Mt Holland is, according to Wesfarmers, a “globally significant hard rock lithium deposit of high grade with a mining lifecycle of over 50 years”. The first ore was mined in December 22, with the first production of spodumene concentrate expected in late 2023. The refinery, which will transform the concentrate into lithium hydroxide, is expected to be up and running in the first half of calendar 2025.
For its part, Wesfarmers is investing $1.2 to $1.3bn capex in the project. Revenue is not expected until the first half of calendar 2024, and then it will be another year at least before this ramps up.
Wesfarmers says that it remains focussed for shareholders on long-term value creation. The company doesn’t provide the market with financial forecasts, but in its February half-year update, it noted continuing cost of doing business pressures. Retail trading results in the first part of 2H23 have been broadly in line with the growth in 1H23, and while demand is expected to be impacted by higher interest rates and cost of living pressures, Wesfarmers is “well positioned with strong value credentials and low-cost operating models.”
What do the brokers say?
The major brokers are largely in two camps. Those that feel a general retail slowdown will impact earnings in Bunnings and Kmart/Target, and those that feel there is upside risk to earnings from lithium and Wesfarmers Chemicals, Energy and Fertiliser businesses. That said, the overall range is pretty tight – from a low of $42.00 from Ord Minnett (Morningstar) through to a high of $56.70 from Macquarie.
On consensus, the target price is $50.54, 2.1% lower than Friday’s closing ASX price of $51.65. Individual target prices and recommendations are set out in the table below.
Interestingly, in Ord Minnett’s assessment, it calculates that the Mt Holland lithium project is worth around 7% of the target price of $42.00 or around $3.00. On multiples, the brokers have Wesfarmers trading on a multiple of 23.3 times forecast FY23 earnings and following EPS (earnings per share) growth of 6.8%, 21.8 times forecast FY24 earnings. The dividend yield is forecast to be 3.5% for FY23 and 3.8% for FY24 (based on a current share price of $51.65).
Bottom line
Wesfarmers is a top quality “blue-chip” stock and despite the conglomerate model, the market is comfortable with its approach and disciplines around capital allocation. But as it heads higher into the fifties, it is starting to get a little expensive. It is certainly no bargain on a multiple of 22 times next year’s earnings, given the risks around consumer spending and sales growth.
My sense is the market is attaching quite a premium to the lithium business and if Ord Minnett is right, it may already be “over valuing” what it is really worth. Lithium mining and refining will be an important asset, but nothing compared to the ongoing growth of the Bunnings franchise. Given that there is a Bunnings store in every major town and suburb, the question remains: how can Bunnings keep growing outside normal retail sales growth rates? Remember, Wesfarmers tried to take Bunnings to the UK and failed spectacularly, writing off around $2bn in the process.
In the low $50’s, Bunnings is a hold for portfolio investors. It’s too late to buy. In the high $50’s, it moves into sell territory. I expect relative market underperformance.
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