Target implosion isn’t a stain on Richard Goyder’s record

Westfarmers managing director Richard Goyder in the fresh fruit and vegetables isle of a Coles Supermarket in Perth. The problems with Target are a blemish rather than a stain on Goyder’s record.

Richard Goyder has had a bad week. For the first time in more than a decade as chief executive of Wesfarmers his continuing tenure has been questioned after the group announced more than $2 billion of impairments against the value of its Target and coal businesses.

While those impairments are non-cash items and won’t impact Wesfarmers’ final dividend this year, more than $100 million of Target losses in the second half, $145m of restructuring costs and provisions and losses from the Curragh coal business that are likely to be around $300m for the year have placed a question mark over Wesfarmers’ ability to maintain its dividend.

About $1.7bn has been wiped from Wesfarmers’ market capitalisation since the impairment charges were announced, even as the overall sharemarket has been edging up.

More than the losses at Curragh which, while having some specific issues with hedging and an uneconomic supply contract, are part of a dismal global landscape for the commodity, it is the continuing implosion in earnings at Target that have triggered criticism of Goyder and even questioning of the original decision to acquire the Coles Group in 2007.

Guy Russo, who led the remarkable turnaround at Kmart, now has carriage of both Wesfarmers’ discount department store brands and it is clearly the group’s last chance at reviving what was once the most profitable major retail business in the country.

What has happened to Target needs to be seen in context.

It isn’t alone. Both the major department store groups, Myer and David Jones, are in the midst of their own major restructurings and Woolworths’ Big W business is in similar strife.

The success of the model Russo created for Kmart is part of the explanation, particularly at the discount end of the department store market. Russo slashed the range of products Kmart stock, focusing on household basics, and has driven massive volume gains to in turn drive down prices to a level that has destabilised the rest of the market.

It isn’t just the Kmart factor, however.

Since Target was acquired in 2007 — it generated $223m of earnings before interest and tax (EBIT) on sales of $2.2bn in 2007-08 — the retail landscape has changed dramatically.

The growth of online retailing is one of the structural changes to the market, with international e-tailing powerhouses like Amazon and ASOS competing alongside a host of international brands selling direct from the websites as well as local flash sites and speciality e-tailers. National Australia Bank’s online retail sales index indicates annual online sales of around $20bn in this market.

There has also been a continuing invasion of international retailers, with brands like Zara, H&M, GAP and Uniqlo all competing directly for what used to be Target’s core market segment of relatively cheap and relatively fast fashion.

The rise and rise of the Cotton On group and the entry of non-fashion retailers like Pottery Barn are other elements of the tidal wave of increased competition to the more price-conscious end of the department store sector.

Russo faces a real challenge in creating a new formula for Target without undermining the continuing momentum at Kmart and cannibalising its sales.

He’s made it clear he aims to lower Target’s cost base and create a more focused offer, which is broadly similar to the strategy he pursued at Kmart. The delicate bit will be positioning Target at price points and with a range of products that attract a different type of customer to Kmart’s.

That’s part of the context in which Target’s problems should be seen and Goyder’s record assessed. The other part is its history and, indeed, the history of Wesfarmers’ acquisition of Coles Group.

Wesfarmers acquired Coles — by itself, after its original private equity partners fled as the first signs of the developing global financial crisis emerged — late in 2007. The nominal price-tag was just over $19bn.

The cash component of the acquisition, however, was only about $6.4bn with the rest funded by issuing Wesfarmers’ shares that were trading at record levels within the pre-crisis sharemarket boom.

It was Wesfarmers’ arguably inflated share price that, under acquisition accounting principles, largely established the book values of the assets it acquired and the $15.6bn of goodwill the purchase injected into its balance sheet.

While the larger part of that goodwill was allocated to Coles’ supermarket and liquor business, Target, because of its profitability, ended up with more than $2bn of it. Two years ago, as Target’s performance deteriorated, about $680m of that goodwill was written off. This week’s announcement will see another $1.1bn to $1.3bn evaporate.

While Goyder and his team could be criticised for being initially too slow to recognise the severity and structural nature of Target’s problems and, in the initial attempt to address them, signing off on a strategy that wasn’t sufficiently radical and aggressive, the problems with Target are a blemish rather than a stain on Goyder’s record.

The other element of the context in which the decline of Target and its significance to assessments of Goyder’s record has to be viewed is the overall outcome of the very brave decision he and his board took back in 2007.

When they acquired the Coles Group its food and liquor business had sales of $16.9bn and EBIT of $474m. Target had sales of $2.2bn and EBIT of $223m. Kmart had $2.5bn of sales and $114m of EBIT. Officeworks had sales of $802m and EBIT of $36m.

Last financial year, the food and liquor operations had sales of $38.2bn and EBIT of $1.8bn; Kmart sales of $4.6bn and EBIT of $432m; Officeworks sales of $1.7bn and EBIT of $118m and Target sales of $3.4bn and EBIT of $90m.

In other words, at the brand level, the businesses acquired have, despite Target’s implosion, lifted their combined earnings from less than $850m to around $2.5bn, with Wesfarmers’ half-year results for this financial year showing that, with the exception of Target, they are continuing to grow sales and earnings strongly.

Wesfarmers “other” retail business, Bunnings, has nearly doubled its sales over the same period, generating $9.5bn of turnover last year, while lifting EBIT from $524m in 2007-08 to just over $1bn last financial year. It has also seen off an attempted assault from a major new competitor and helped severely destabilise Wesfarmers’ rival, Woolworths, in the process, by killing off that group’s $3bn Masters joint venture with Lowe’s of the US.

Unhappily for Wesfarmers, the accounting standards don’t allow it to revalue Coles, Kmart, Officeworks and Bunnings upwards to reflect the value added, which is clearly very substantial.

A legitimate criticism of Goyder and his board, or at least a major debating point, has been their reluctance to accept that Wesfarmers’ traditional diversified conglomerate model has been rendered redundant by the success of Coles, Kmart and Officeworks.

The shortcomings of the “loose/tight” operating model that underpins it — considerable operating autonomy for its business units twinned with tight financial controls — were exposed by the accounting scandal, relating to supplier rebates, at Target earlier this year.

Wesfarmers’ non-retail earnings are now insignificant and its industrial and resources units immaterial relative to the big retail brands within the group. They’re simply a distraction from the main game.

If John Gillam and his team are successful in using the UK launch pad, Homebase, that they acquired for $700m or so early this year to replicate key elements of the Bunnings model, the non-retail businesses will become even less meaningful and Wesfarmers will be under even greater pressure to remake itself into a pure retailer — albeit, perhaps, a conglomerate of retail brands.