Cash from Coles

Wesfarmers reported a first-half FY20 net profit from continuing operations of $1.142bn (pre AASB 16* accounting), up 5.7% on the same period last year and above Ord Minnett’s $1.049bn forecast. A fully franked interim dividend of 75cps was declared, versus our 69cps estimate.

 

Operating (pre ‘other’) earnings before interest and tax (EBIT) of $1.565bn fell 3.3% on a year ago, with ‘other’ and property gains (within operating EBIT) being a low-quality source of EBIT, although provisions also weighed on earnings.

 

By division, Bunnings’ like-for-like sales growth was strong at 4.7%, while EBIT grew with modest EBIT margin compression. Kmart and Officeworks also performed well. The industrial and safety division (WIS) and Target endured payroll remediation costs but still delivered very weak results, with these businesses having been challenged for some time. Meanwhile, the EBIT contribution from the chemicals, energy and fertilisers business (WESCEF) fell and is forecast to continue to decline. Operating cash flow was above our forecast, however, with 107% cash conversion.

 

Wesfarmers has sold 4.09% of Coles Group (COL, Lighten) for $1.05bn, with a pre-tax profit of $160m, and will retain a minority interest of 10.1%. The company has not yet revealed the intended use of these proceeds.

 

Wesfarmers is facing a challenging FY20 as underlying earnings growth slows for many divisions. Bunnings remains resilient with strong LFL sales and EBIT growth, while the remainder of the businesses, face challenges from labour costs (Kmart, Officeworks, Target and WIS) and competition (Officeworks, Target and WESCEF), and Target and WIS seek to recover from another weak year of financial performance.

 

For FY20, we forecast a 3% decline in operating EBIT – pre Coles and ‘other’ – with a possible recovery in the lower-multiple divisions and a strong performance from ‘other’, the driver of stronger rates of EBIT growth. We see a lack of valuation support based on our discounted cash flow valuation, P/E multiples (which are high historically and reflect a consumer staples business rather than a consumer discretionary company), albeit with a resilient Bunnings, and a sub-4% dividend yield.

 

We maintain our Lighten recommendation with a $39.00 target price.

 

* The AASB 16 accounting standard removes the distinction between operating and finance leases on a company’s balance sheet.  

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