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Is Wesfarmers’ Price Justified?

Is Wesfarmers’ Price Justified?

The following column first appeared in Alan Kohler’s Eureka Report earlier this week…

Reading the headlines lauding Richard Goyder’s “audacious” and now “successful” bid for Coles and the almost lyrical waxing of the turnaround, you’d be forgiven for thinking you should buy shares in Wesfarmers immediately. But rarely is impatience rewarded, so before you rush in consider the following.

The enthusiasm surrounding Wesfarmers’ results last Thursday can only be justified if your sole focus is growth. Coles outpaced Woolworths’ sales growth in the half-year to December for the first time since the early 1990s and volume growth of food and liquor has risen in each of the past five quarters to now exceed 7%. Kmart’s turnaround has been impressive, with returns on invested capital more than doubling, and the liquor business – which includes Liquorland and Vintage Cellars – has delivered the targeted increase in market share and won share from arch-rival Dan Murphy.

But all is not as it seems, and in investing it is always best to be sceptical. Let’s start with the liquor strategy.

The company’s liquor strategy is to win market share by discounting and then improve margins later. Improving margins may involve raising prices, which could lead to a loss of market share. Improving margins can also mean cutting costs.

But keeping overheads low for a retailer should be like breathing is to you and me: automatic. Implementing a cost cutting “strategy” at a later date is akin to deferring breathing – not wise. And while Kmart’s improvement in return on invested capital is impressive, one does wonder how arbitrary the allocation of the invested capital to Kmart is.

More importantly, buying shares in Wesfarmers, buys you a lot more than Coles, Liquorland and Kmart (or a lot less, depending on your perspective). One share of Wesfarmers buys you a (now much smaller) piece of a conglomerate that includes coal, insurance, chemicals and a hardware business.

When all businesses are included it’s difficult to share the market’s enthusiasm. Net profits rose from $871 million to $879 million – less than 1% – and on a per share basis the earnings actually fell 26% from 103.3¢ per share to just 76¢. This is because capital was raised to pay down debt.

Debt reduction via equity issues rarely produce desirable results for shareholders. On the one hand there’s the fact that shareholders are investing capital in a business at a return equal to the interest rate on the debt. This dilutes overall returns on equity and presents shareholders with a very low return for their risk.

On the other hand, the number of shares on issue rises, and for Wesfarmers the number was significant because much of the raising was done at prices less than the equity per share. Using the same share price, buying $10,000 of Wesfarmers’ half-year earnings in 2009 would have cost you about $293,000, for 9680 shares. In 2010, the same share of earnings now costs almost $400,000, for just over 13,100 shares.

Dilution aside, growth is always a component of my calculation of intrinsic value. Sometimes it’s a variable that has an enormous impact and sometimes it has none. More surprisingly, perhaps, is the fact that growth can be both a positive and a negative contributor to the estimate of intrinsic value.

When return on equity is low, growth hurts the investor because profits have to be retained to fund the growth. These profits, however, are being employed at low rates of return that represent an opportunity cost and fail to reflect the risk associated with the investment.

Using the company’s own data, combining Coles, Officeworks, Target and Kmart’s $1.6 billion EBIT and comparing it to the capital invested of $20.4 billion, produces a return of 7.7%, about the same as a five-year term deposit. And while I know the reasons for using EBIT, in reality someone has to pay the interest and the tax and so an owner’s return should look at NPAT. Taking the enthusiastic analysts’ optimistic forecasts for earnings, Wesfarmers returns on equity are forecast to improve from a rather miserly 6.5% this year to just under 9.5% in 2012.

As a result, Wesfarmers’ per share intrinsic value is nowhere near the current price. This year intrinsic value is about $12 per share, rising to about $16.50 next year. With the shares trading today at $30, you may be wondering how the market could be so wrong? Or more likely, how could Roger be so wrong?

When Telstra traded at $9 and my valuation came out at less than $3, or when investors bought Myer at $4.10 and my valuation was under $3, I thought the same thing. In the short term the market is a voting machine – a popularity contest – and for time immemorial it votes with growth. Think ABC Learning, Babcock and Brown, Allco.

Wesfarmers should not be compared to these examples; over the long term however the market is a weighing machine and price follows valuations. Intrinsic value is based on profitability – how many dollars are required to be invested to get that dollar of profit out – rather than profits alone and Wesfarmers’ profitability simply doesn’t justify today’s price.

Roger Montgomery for Alan Kohler’s Eureka Report. www.eurekareport.com.au

Posted by Roger Montgomery, 26 February 2010


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. What industry do you work in?
    Currently airline services
    Who do you regard as the best company in that industry?
    What do you think makes them the best?
    Service branding
    Could anyone eventually knock them off the perch? Not at present.
    Who do you think is the most likely to?
    No idea.
    What other industry(ies) do you like? Why?
    Didn’t say that I like this industry, but they do pay the rent. :)
    I like food and basic consumer at the moment, because I think that they are the most resilient to any long-term recession conditions.
    Australia’s obsession with buy-now pay later will take a lot of whacking around before we change, and these sectors are best able to exploit this.
    Do you receive tips?
    Yes, mostly terrible ones.
    I treat tips like I treat door-to-door/tele sales. If i want something, i’ll go out and find it – I don’t need it pointed out to me.
    How do you test them?
    I use the value tests that you have already covered well enough in this forum.
    I do try to help other people with a fair valuation for them, but most people ignore my tips, because the tips are too boring – Like
    buying a share and never selling it again. Everyone fancies themselves as traders, not accumulators.
    The weirdest ones I have been hearing lately are people who intend to travel OS and are buying xyz currency. As far as I can see, the only people who make money out of currency trading are the agents – Just like bookies at the racecourse.

    Do falling shares prices make you freeze?
    Not any more. I quite often get excited these days – I have a list of shares that I am watching for opportunities to buy.

    Does your share portfolio have so many shares that it looks more like a museum? No. Fortunately I got value investing education before I started.

    How do you track your portfolio’s performance?
    Not with too much detail. I’m more concerned about individual businesses performance against what they planned to do.

    How do you go about analysing a company?
    I look at market staples, keep a watchlist in my tracking software, then wait for what I consider to be reasonable safety margin. This is usually market price = ~60% of the valuation.

    What’s has been your process for investing?
    One other thing I do apart from the std value investing, is, use the 1/2 Kelly Criteria to determine an approximate amount to invest and have invested in the market. I like the way it optimises chance.

    What stock do you like the most?
    My best purchase has been some ‘preferreds’ that I bought when they were trading at ~$1.10. I bought three tranches, which averaged my holding to $1.20. The holding is paying me dividends ~15% net. Hooray!
    Why do I like them?
    They are still very conservative, high in cash and equivalents, and they got me looking at more complicated share choices (e.g. preferred shares)

    • Hi Steve,

      Another extremely valuable post with some real gems. Comparing a company’s performance to what was delivered is such a simple thing to do and its only cost is time. Just printing off every Chairman’s letter from the last ten annual reports and reading the compilation like a book, tells a great deal about the people running the company and their ability to deliver on so many levels. While conducting such research will reveal whether the culture is to over promise, it will also reveals managements’s ability to explain and describe what they do. if they cannot explain it to you succinctly, how do they explain it to their staff and customers?

    • BTW, in the Eureka piece about China, Iron ore and Coal you say: “China buys almost three-quarters of Australia’s coal exports – 280 million of their 630 million tonne demand”. I’m pretty sure you meant three-quarters of Australia’s iron ore demand. Japan and Korea are Australia’s biggest coal customers, and only 9.5% of Australia’s coal goes to China.

    • Hi again Mr Sink,

      Not personally having a firm view either way, I nevertheless want other investors to be aware of the talk of a cloud forming on the horizon. The article is very likely to be found in the next few days by clicking on the MEDIA tab at the top of the page and then by clicking OFF THE PRESS.

      • Great, it would be nice if you could create a blog post on this topic so we can continue this discussion, because IMO this is by far the most important risk ahead for investors. A China “speedbump” would affect all equities, regardless of direct exposure to China.

        You might not have a firm view either way, but Mr Stevens, Mr Battellino and Mr McKibbin certainly do, and they have bet the farm on a 20 year China boom.

  2. Hi Roger

    I often see quoted the P/E ratio of the whole market. This seems to be used to estimate how “under valued”/ “over valued” the market is. I understand the problems with this ratio. Is possible to calculate the ROE or IV for the whole market? If it could, would this be a useful measure or a waste of time?


    • Yes, I do it for the ASX 200 and I find it extremely helpful. I have presented it on Richard Goncalves program at Sky Business. WOuld anyone else be interested in a valuation of the index – which as you might know is a weighted average of the values of the all the stocks that make up the top 200?

      • Roger, I have read your views on P/E ratios and agree that they can lead to poor investment decisions. However, this is only the case in a relative sense i.e. two companies with different historical and prospective ROEs can have the same P/E ratio but different intrinsic values – the company with the higher ROEs is probably undervalued and the one with the lower ROEs is probably overvalued even though they have the same P/E ratio.

        P/E ratios tell you something about the way the market is “pricing” a particular business; whether that “price” is a reasonable reflection of the business’s “intrinsic value” depends on the investor’s assessment of future prospects and the risk associated with those prospects. So, P/E ratios can still be useful in investment analysis in an absolute sense. For example, if a company like ABC Learning, with a low ROE and high levels of debt, trades at a P/E multiple of 25 times I would argue its “expensive”. However, if a wonderful business like Coca Cola is available for a P/E multiple of 10 times, I would argue its cheap given its great prospects.

        Great investors like Buffett and Graham do refer to P/E multiples and seem to use it as one indicator of under/overvaluation. However, Buffett makes it clear in his letters to shareholders that measures such as P/E multiples, dividend yields etc etc are only useful in valuation to the extent to which they tell you something about the future prospects/cash generating ability of a business.

      • Hi,

        Thanks for your thoughts. In keeping with the theme of my blog, please use your real first name in your next message, otherwise I won’t be approving it. I hear what you are saying about P/E’s. The reality is that you are correct insofar as they tell us what others are prepared to pay. At extremes perhaps they can highlight “cheap” and “expensive” but I find “intrinsic value” tells us a lot more. Interestingly you yourself say that you find P/E’s useful when looking at them with ROE’s. Thats probably the point. You are no longer looking only at P/E’s to tell you that something is cheap or expensive.

  3. Thanks Roger

    Could you please comment on the impact of WOW’s share buyback? Or in general regarding share buybacks at below and above IV.

    Thanks DC

    • Hi DC

      Nice question and looking forward to Roger’s comments too. (Thanks Roger!)

      In a flukey coincidence, I have just been reading some of Buffets letters to shareholders, and in the 1984 letter he explains his thoughts on buybacks (or repurchases as he calls them) – maybe of interest?

      (Starts with “When companies with outstanding businesses and
      comfortable financial positions find their shares selling far
      below intrinsic value in the marketplace, no alternative action
      can benefit shareholders as surely as repurchases – 8th paragraph below the first table: http://www.berkshirehathaway.com/letters/1984.html)

      • Hi DC and Mick,

        Much as you increase your wealth by buying below intrinsic value and selling above, companies who act the same way on behalf of their shareholders produce the same result. Witness CSL’s (or was it Cochlear’s?) issue of shares at a high price – and being unable to deploy the cash for its intended acquisition, then returned the money buy buying the shares back at a much lower price. The result of selling high and buying low is the addition of cash book value per share to remaining shareholders.

  4. Hi Roger,

    Regarding your comments about retailers in Australia reaching saturation as they can only grow so big in Australia when you mentioned this about JB Hi Fi, would Wesfarmers & Woolies not be too far away from this point? How much growth is left in these two companies as it seems that there are Woolworths or Wesfarmer owned stores on almost every corner? Is Woolworth’s strategy of moving into the hardware sector a good move considering that it’s not expected to pay off for some time, the capital required to be invested and an already dominant competitor in the sector?



    • Hi Ross,

      With 22 million people everything reaches saturation eventually. Of course further growth can come from price rises and cost cutting or the same number of people increasing their basket size. Its when the institutional investor imperative to grow pushes a company beyond its boundary that problems occur.

  5. I seem to believe that last week, there was a headline on news.com.au where the analysts thought the result was good and ‘in-line’ with expectations – I believe it trumpeted “1% growth in profit”. The figure of 1% clearly sticks out in my memory, because I thought “what ?!” at the way such ‘rational people’ were thinking it was great – and another rival company trounced them the same week.

    Roger, please tell me that I am not imagining things ?!

  6. Hmm to sell now @ 50% above the IV and pay CGT @46.5% on the gain from a cost base of $15.00 (ok 50% discount available) or wait until (if) the “market” catches up with the IV and watch the gain erode.

    While selling will always be influenced by personal circumstances /tax situation, some general thoughts on selling and the issues to consider would be helpful.




    • Hi David,

      SO are you suggesting to wait two, three, four or more years for the value to catch up and then pay the same tax anyway? I have an entire chapter devoted to the five rules for when to sell. As a patient value investor, I am sure you will be happy to wait for the book…

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