Wesfarmers UK expansion plans to be hit by Brexit storm: BAML

The possibility of a Brexit-induced recession doesn’t bode well for Bunnings’ UK expansion, says BAML.

Forecasts of a Brexit-induced British recession do not bode well for Bunnings’ UK expansion plans, according to BAML. Chris Ratcliffe/Bloomberg

The Brexit vote will plunge the UK economy into a recession, according to Bank of America Merrill Lynch, which throws even more doubt on the merits of Wesfarmers’ $685 million acquisition of UK home and garden retailer Homebase.

In a report released late last week, BAML analyst David Errington said, at best, that: “If Wesfarmers cuts its losses and eliminates any plans in the foreseeable future to grow Homebase, we believe the damage to shareholder returns can be isolated to the initial capital outlay (just under $700m) and the capitalised value of the lease commitments (which we estimate to be around $2bn).”

The analysis is based on forecasts of a recession which is yet to evolve and the reaction of consumers to the economy in an uncertain environment.

It also ignores any adjustments by Wesfarmers to the changed circumstances.

“Wesfarmers has put forward a plan to spend up to $1bn to refit, restructure and reposition the Homebase stores and customer offer (over the coming 5 year period). If Wesfarmers continues its current plans, and commits the capital to Homebase, we believe the operating losses will increase (due to the restructuring) and the overall value erosion to shareholders will escalate (capital loss and increased losses).”

Bunnings boss John Gillam has made clear there are plenty of problems with the existing Homebase stores which his team are now trying to rectify.

This includes a change to everyday low pricing and better purchasing policies.

A lower pound sterling will clearly impact the cost of imported items in the short term.

The Wesfarmers plan is to rebase the stores and convert them into Bunnings stores, albeit on a smaller foot print at around 7,000 square metres against the average warehouse size in Australia of 14,000 square metres.

The report is based on the call by BAML’s economists which argues: “The UK will fall into recession (2.5 per cent coming off GDP), we now believe that Homebase’s earnings will quickly dissolve to negligible levels (i.e. be break-even at best). We think it is possible that heavy losses may be recorded.”

The UK call is a big one given the uncertainty that now exists over the impact of the Brexit vote.

Bunnings boss John Gillam has stressed further investment in the UK will be dependent on a pilot store to be opened by year’s end.

The Brexit vote was part of the Wesfarmers due diligence on the acquisition and the Errington analysis.

It has made clear that the restructuring of Homebase will take five years and the performance of the UK economy over that period is subject to many variables.

Australian experience has shown that when economic times are tough, people spend more on do-it-yourself home renovations.

The doomsday scenario for the UK economy is not a universal call.

Errington has a long-term buy on Woolworths and a sell on Wesfarmers backs this call.

He said, “In our view, it will be many years before Homebase (in its current position) generates any or reliable profit and hence we believe the initial investment Wesfarmers made ($700m) has a zero value.”

That is clearly a view rejected by Wesfarmers.

Errington said: “If Wesfarmers elects to push on with its plans to spend $1bn in restructuring the business (which we believe would add little to the opportunity of Homebase to return to profits), the capital lost to shareholders would grow up to $4bn.”

“Our economics team anticipates the UK could enter recession following Brexit. We expect significant macro, currency and political risk arising from this event which is likely to have a flow on effect to consumer confidence for some time to come. The housing market is also likely to suffer in this environment and we would expect the consumer discretionary market Homebase operates in to contract sharply,” he said.

“The UK home and garden market growth has been low for an extended period and has recently recovered to around 1 per cent as seen in Chart 1. The euro crises of 2010/11 coincided with a detraction in sectors correlated to consumer cyclicals (such the home and garden market). During this period, the home and garden market contracted by around 0.5 per cent. Interestingly, this had the effect of reducing EBIT by around 25 per cent for Homebase and B&Q (on an indexed total EBIT basis),” Errington said.