Wesfarmers on course for its own Masters disaster in UK, says BAML

Wesfarmers’ expansion into the UK is likely to be a repeat of Woolworths’ Masters fiasco warns BAML.

A pedestrian walks past a Homebase store in London. Chris Ratcliffe/Bloomberg News

Wesfarmers faces lower dividends and a fall in its credit rating due to a combination of declining earnings from its industrial businesses and an ill-fated expansion into the UK, according to Bank of America Merrill Lynch (BAML) analyst David Errington.

The note published today is the latest in a series of reports from Errington that are against Wesfarmers and for Woolworths, with him having a buy on the latter and a sell on the former.

“We were critical toward Woolworths entering the Australian home improvement sector (via Masters), and we believe Wesfarmers entering the UK market (via Homebase) will be as equally a compromising decision for Wesfarmers as Masters was for Woolworths,” he said

Errington said paying $705 million for a business generating earnings of $40m “raises questions”.

At next week’s strategy briefing, Bunnings boss John Gillam will outline the latest feedback from the UK Homebase acquisition.

Earlier this year, Gillam said the property costs in the UK were higher at something like 2.6 times the percentage of sales paid in Australia. Gillam has said it will take two years before Wesfarmers will be able to show whether the acquisition will be successful.

Errington put a figure of $600m on rental costs.

Gillam will put the case next week for the company to open a pilot store in the second half of this year and, depending on its performance, roll out stores from there. But he will stress the company is not committed to spending any money in the UK unless it is justified.

He will also make clear that the Homebase business is not great, adding that the acquisition gave Bunnings a licence to operate in the UK not an operating business.

Because the rental costs are high, he will operate in smaller format stores much akin to Aldi and Lidl in the UK who are enjoying fast growth over the bigger majors in their large format stores.

Gillam declined comment on the Errington note pending his briefing next week.

Errington argued the fixed charge ratio (which measures costs and balance sheet risk) at Wesfarmers fell from 3.17 in 2014 to 2.99 last year and would fall to 2.54 this year and 2.44 in financial year 2017.

He also noted the company has been spending over two times depreciation in capital expenditure and paying out 90 per cent of earnings in dividends.

Wesfarmers is now on a “A minus” rating compared to Woolworths at “BBB” and Wooldworths has a fixed charge ratio of 2.4.

Errington noted coal would lose $300m this year extending on the $130m loss in 2014, Target would lose $200m compared to a profit of $90m last year, industrial supply would earn just $27m this year, down from $70m and rental costs in Australia had increased by $100m.

Errington forecasts dividends will fall from $2 a share to $1.80 over the next two years.

“We believe that Wesfarmers buying Homebase in the UK will be the equal (in terms of underlying dent to investor returns and business performance) as Masters has been to Woolworths,” he said.

“Due to the planned overhaul of the Homebase business, we believe marketing costs are likely to be hefty as Bunnings has no brand recognition in the UK. We have concerns that Homebase will likely “chew up” any profits currently being generated in re-branding, marketing, pricing and service costs,” he added.

Errington said “The growth in the home and garden market in the UK has been low for an extended period as shown below. The current five year CGAR suggests growth has been below 1.5 per cent. Homebase currently holds about 3-4 per cent market share and we question its ability to grow in a slow market against a backdrop of economic uncertainty (Brexit, global GDP concerns).”