Wesfarmers may not be as resilient as it claims

Earnings at Bunnings-owner Wesfarmers are under threat as rising rates and falling house prices in Australia's biggest cities threaten consumer spending, according to several analysts.

With the central bank raising interest rates by 50 basis points this month, and more expected in July and August, growing pressure on households’ budgets is expected to dent non-essential spending, including home improvements.

At an investor strategy day early in June, chief executive Rob Scott emphasised that even if consumer confidence and spending deteriorates, Wesfarmers’ diversified business portfolio could provide some downside protection to earnings. As consumers turn value conscious, Wesfarmers (ASX: WES) is betting its stable of discount brands like Kmart and Target can also take market share from more expensive competitors.

But Morningstar consumer analyst Johannes Faul says that protection is likely to be limited.

“Although we agree with the logic, in contrast to Bunnings, Kmart Group makes up a relatively small part of Wesfarmers’ portfolio. We forecast Bunnings to account for 60 per cent of Wesfarmers’ pre-tax earnings in fiscal 2023, with only 17 per cent coming from Kmart Group,” says Faul.

“So, the level of protection needs to be put into context,” says Faul. He has a fair value on the stock of $41. However, at Friday's share price of $43.81, Wesfarmers shares still screen as overvalued, he says.

Wesfarmers has been hit hard in this year’s market selloff, declining 26% compared to 11.6% for the broader S&P/ASX 200.

Goldman Sachs strikes a similarly pessimistic note and sees “better value elsewhere,” adding that Wesfarmers’ risk profile is elevated at the current juncture. Goldman recently lowered it price target for Wesfarmers to $40.00 from $39.40 and has maintained its Sell rating on the company.

“We see that Wesfarmers is undergoing a period of elevated investments at a time when its core engine Bunnings is challenged with softening macro and the Kmart business requiring higher inventory to manage through supply chain volatilities,” said a Goldman research note.

Wesfarmers’ retail businesses include six of Australia’s largest retail brands. Its Bunnings hardware chain is number one in market share, discount department stores Kmart and Target are number one and three, respectively, and Officeworks office supplies business is number one.

At its strategy day, the conglomerate also announced it was enhancing its online operations to reduce costs and it has accelerated the rollout of its OneDigital online retail business and data analytics centre. It is also taking measures to improve its supply chain given huge disruptions during the Covid-19 pandemic.

Bucking the pessimistic trend among analysts, Morgans has a Buy rating on Wesfarmers and a $58.40 price target. Wesfarmers is well-positioned for a tough retail environment, partly to its focus on value with its popular Kmart business, said Morgans analyst Alexander Lu. “We continue to see Wesfarmers as a long-term, core portfolio holding with a strong mix of businesses, highly regarded management team and a healthy balance sheet.”

Bunnings at risk from falling house prices

With much home renovation spending considered discretionary, some analysts predict Wesfarmers’ core asset Bunnings will be hurt by the potential housing slowdown in Australia’s biggest cities.

Faul says that Bunnings remains exposed to cyclicality in Australian construction activity, “with retail sales highly sensitive to the housing market and consumer confidence”.

Citi agrees and says Bunnings sales show some correlation to house prices. The investment bank has predicted that “falling house prices are likely to result in low single digit like-for-like sales growth as opposed to high single digit sales growth when house price growth is strong.” Citi has a Sell rating on Wesfarmers.

Morgans counters this and says Bunnings’ earnings have been resilient over time, with Australians traditionally investing in their homes through all economic cycles. “The structural shift to greater working from home is a tailwind for Bunnings as it increases the need for repairs and maintenance and encourages people to do more in the home environment,” says Lu.