Australia | Apr 29 2020
What can Wesfarmers do with its underperforming chain, Target? Brokers suggest the laggard of the group may be in line for a severe reassessment.
-Bunnings and Officeworks underpinning strong sales in March quarter
-Plenty of funds for M&A albeit track record is patchy
-Is closure the best solution for Target?
By Eva Brocklehurst
Bunnings and Officeworks continue to provide strong growth for Wesfarmers ((WES)) as consumers, locked down to their local environment, undertake more DIY chores and, those that can, work from home.
Target and Kmart on the other hand continue to present challenges, with a marked slowdown in sales and heightened discounting in April. Wesfarmers has signalled a strategic review of Target, to be completed by June, highlighting potential for significant changes to address the underperforming business.
Credit Suisse assumes the market will continue to price the stock on the basis of Bunnings, which experienced a 5.8% increase in March quarter sales. For Macquarie, this implies Bunnings is gaining share over hardware competitors. The online business is also very strong.
However, the broker cautions that recent data indicates both hardware and office categories will moderate and move into negative territory, the increased cost of servicing online demand will weigh on margins, and this will only partially be offset by the benefit from reduced promotional activity.
Meanwhile, Kmart and Target sales in the March quarter were broadly in line with the first half, showing growth of 7.6% and a decline of -4.3%, respectively. Ord Minnett points out three Kmart stores have been converted to "dark" stores, fulfilling online orders only, while Kmart and Bunnings (excluding trade) have been closed in New Zealand since March 25.
Wesfarmers has also around $4bn of funding headroom, placing it in a strong position to undertake strategic options. The company has extended its debt facilities by $2bn and UBS estimates Wesfarmers has $7bn in liquidity, supporting the dividend and providing the ability to assess opportunities when and if they arise.
The strength of the balance sheet and acceleration in trading at Bunnings is supporting the business yet, in Citi's view, reflects a premium for the successful redeployment of capital that is not justified by the company's acquisition track record.
Ord Minnett agrees, while the company is well capitalised, its acquisition track record is patchy, although the divestment track record is better.
There is no simple answer to the problems of Target, Credit Suisse points out. The business is positioned in a very competitive part of the clothing market. Store closures are likely to lower the overall distribution costs and extend earnings and, admittedly, there is some value in this.
Kmart remains profitable and re-branding more stores to Kmart may mitigate the downside, but there remains a limit to how many Kmart stores can be supported. Clearing stock for either store in a weak environment for foot traffic is challenging, Citi asserts, particularly without high online penetration.
Ord Minnett points out, over the past 20 years, Kmart and Target have rarely performed well at the same time. Moreover, Kmart has evolved from the discount department store space while Target faces competition from online apparel retailers that enjoy greater scale.
The broker expects an acceleration of conversions to Kmart, or closures of metropolitan stores, and a focus on online and/or regional stores that cannot justify converting to Kmart. Morgans expects all options will be on the table including the possible sale of the business, mass store closures and/or increased conversions to Kmart.
Again, Credit Suisse asserts that fundamentally repositioning Target would be costly and the outcome uncertain. In a bear case, with the business shut, the broker assesses there would be around $2bn required to pay out leases, stock exit and redundancies. Still few solutions are likely to be financially attractive and the continuation of simple incremental changes appears unsustainable.
Citi calculates closure or a significantly reduced Target could cost between $800m-1.5bn in cash and non-cash provisions. Given the capital required to sustainably turn the business around, the broker comes to the conclusion closure is the best option and values Target close to zero.
Goldman Sachs, not one of the seven stockbrokers monitored daily on the FNArena database, calculates Target needs to close at least 20% of its stores, on top of those 14 already closed since 2018. The broker now expects a -21% reduction in store space by FY25, or over 70 stores across Target.
Goldman Sachs believes it unlikely Wesfarmers will shut Target entirely, given the potential disruption this would create for Kmart and forecasts a sharp margin downturn at Target, and to a lesser extent Kmart, before recovery begins in FY22. The broker has a Neutral rating and $37.40 target.
UBS and Macquarie estimate Target is now loss-making and struggling for relevance. Macquarie asserts FX pressures called out in the first half have likely worsened and the company has indicated that the high degree of fixed occupancy costs will weigh materially on profitability.
The database has one Buy (Macquarie), four Hold and two Sell for Wesfarmers. The consensus target is $35.48, signalling -4.8% downside to the last share price. Targets range from $30.90 (Citi) to $40.90 (Macquarie).
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