The disconnect between Wesfarmers' (ASX: WES) 3 per cent dip in operating profit for first-half 2020 and its "ritzy" share price is a prime example of investors ignoring risk, Morningstar says.

The retail conglomerate owner of Bunnings, Kmart and Officeworks – which earns a Morningstar Wide Moat – on Wednesday reported $1.56 billion in group earnings before tax for the half, down from $1.62 billion a year earlier.

News of the company’s admission of $24 million in underpayments to staff in some of its companies, including $9 million at Target, overshadowed the result.

While regrettable, the payroll errors spread over 10 years will have little long-term effect on the almost $53 billion company, says Johannes Faul, a Morningstar senior equity analyst and director.

The relentless climb of its share price, which is currently around 50 per cent higher than what Faul believes the company is worth, is one investors are watching.


Faul suggests this may be an example of investors placing too much emphasis on top-line rather than risk-adjusted returns, as discussed by Morningstar head of equities research Peter Warnes in the latest Your Money Weekly.

Wesfarmers' share price hit $45.85 after the result, and remains at historical highs.

"At these levels, the share price is a little ritzy," Faul says. "The market is clearly looking past the weak outlook for the remainder of fiscal 2020."

He says the Target department store and the industrial and safety segment will likely remain turnaround stories through 2020.

And Officeworks is seeing a marked rise in labour costs, while a competing ammonia plant is likely to weigh on WesCEF's explosives profits.

WesCEF is Wesfarmers' chemicals, energy and fertilisers business, which also produces around 230,000 tonnes annually of explosive-grade ammonium nitrate.

Morningstar's fair value estimate of $31.50 for Wesfarmers is based on a price-to-earnings ratio of around 19 per cent. But it's currently trading at a PE ratio of about 27 per cent.

"The PE ratio of 27 looks pricey against our five-year earnings per share compound annual growth rate forecast of 6 per cent," says Faul.

"Even on longer-dated PE's Wesfarmers is fully priced, with multiples of 26 and 24 in fiscal years 2021 and 2022, respectively."

The most valuable business of the conglomerate, hardware chain Bunnings, comprises around 60 per cent of group profits and is operating in line with Faul's expectations.

Sales growth of 5.3 per cent for the half was just a couple of basis points shy of Faul's forecast.

Bunnings' EBIT margins of just over 12 per cent – down 20 basis points year-on-year – also aligned with his expectations.

"Management's outlook was cautious, expecting moderate trading conditions to continue," Faul says.

"However, over the long term we expect Bunnings to continue broadening its product offering and increase its market share."

Coles: 'No margin of safety'

Supermarket giant Coles (ASX: COL) also remains over-valued, trading above $16 a share after management reported its second successive half of profit growth. Underlying EBIT rose 0.4 per cent to $725 million.

It was also caught up in the underpayments scandal, having been owned by Wesfarmers until it was spun off at the end of 2018. But as with Wesfarmers, Faul doesn't factor this into his long-term outlook for Coles.

The supermarket retailer, which Morningstar doesn't regard as holding an economic moat, has seen its share price gain more than 40 per cent over the last 12 months.


"Coles is proving it is a resilient business, but we contend the upside is limited," Faul says. "We struggle to see a suitable margin of safety at the current PE of 25."

Morningstar's fair value estimate of $12.50 – unchanged after the latest earnings announcement – is based on a PE multiple of 19. This is broadly in line with that of the S&P/ASX 200.

Across the supermarket, adjusted earnings of $637 million for the half met Morningstar's estimates. And margins were helped by Coles' cost-cutting program.

But Faul doesn't expect these measures will continue drive long-term improvements to the segment's EBIT margins. "We anticipate any net cost improvements are likely to translate into price cuts to defend market share," he says.

Margins in Coles' liquor division were hit by lower prices due to a shift in the product line-up, but Faul expects improvement in fiscal 2021. His EBIT margin forecast of 4 per cent for this division is unchanged.