- Wesfarmers sales growth reasonable on a net basis
- Yield is attractive
- Coles appears to be slowing
- Analysts question a high PE

By Greg Peel

Wesfarmers ((WES)) reported its quarterly retail and coal sales last week and the story was mixed.

Brokers have been wondering for a couple of quarters now whether the Coles turnaround story had reached a peak following the supermarket's success in silencing the early sceptics. Within a net 4.8% lift in first quarter retail sales, Coles like-for-like sales growth fell to 3.4% from the previous quarter's 4.5%. To be fair, Coles was hit with double-digit price deflation in fresh food, a number consistent with figures within last week's September quarter CPI release.

But is this the whole story?

Deutsche Bank concedes it would be hasty to draw a conclusion before rival Woolworths ((WOW)) releases its sales result this week. However, Deutsche notes irrespective of food deflation, volume appears to be slowing. Margin expansion in Coles' food &liquor business was soft in the second half of FY13, which suggests to the analysts that "maintaining the earnings momentum may become increasingly difficult". UBS further notes Coles' market share gains "disappointingly" slowed in the first quarter. JP Morgan suggests the pace of the Coles turnaround "is moderating somewhat".

Piffle, says Credit Suisse. "The Coles result was influenced mainly by higher than expected deflation in fruit and vegetables," the analysts point out, "which from a profit perspective is of little consequence".

CIMB picked up on another factor, with regard to petrol discounting. Coles made a tactical decision to redirect promotional spending away from petrol discounting in the quarter in question, but clearly the strategy has fallen short of expectation. Late in September, management decided to hastily reinstate significant discounts, despite the cost, which suggests a plan to reinvigorate momentum, the analysts believe.

Wesfarmers is nevertheless not just about Coles. Bunnings is posting its best numbers in years. Lower interest rates, the beginnings of a housing recovery, and even warm, DIY-friendly weather over winter has helped Hardware Hell along at a time the Woolies pretender, Masters, is clearly struggling to gain any traction.

K-Mart also posted a solid result, but the runt of the litter was Target. Despite negative sales growth, Target is at least showing indications of its own turnaround under new management and the figures are becoming less worse. But if Target starts to regain market share, who will it regain it from? The other low-price chain? Well that would be K-Mart.

Let us not forget that Wesfarmers also produces coal, and here a 5% increase in prices for the quarter was pleasing. Credit Suisse suggests the bottom of cycle earnings for coal may now have been reached and modest upgrades could follow over the next twelve months.

And Wesfarmers' insurance division continues to show signs of recovery.

The good news for shareholders is Wesfarmers' policy of providing attractive capital returns. The conglomerate generates a lot of cash and has now passed beyond the bulk of its turnaround-spend. FNArena database forecasts suggest an FY14 dividend yield at the current price of 4.6% and an FY15 yield of 5.1%, fully franked, which is not far off the big banks.

The bad news is the price. Wesfarmers is trading at around a 20x price/earnings multiple on FY14 forecasts while delivering only around 5% compound annual earnings growth. For many brokers, that equation just doesn't add up. Notwithstanding Coles is appearing to wobble, Target still needs work and a resource sector recovery is not on the cards for tomorrow.

One is tempted to hark back, nevertheless, to when Woolies' PE broke above 20x back in the noughties. At that stage, analysts started applying the Sell ratings. By 25x, analysts were dumbstruck at the market's folly. As the PE approached 30x, some gave it away and started lawn mowing services. You just can't justify such a lofty PE for a business that sells bread and milk.

As it was, the GFC saved the day. But we have to concede things were a little different back then. The economy was booming and Australians were spending money like there was no tomorrow. The supermarket business was undergoing a revolution as Woolies soaked up the spoils of its move into liquor stores and petrol stations, the latter in particular driving cross-promotional market share gains of epic proportions. The company also turned the screws on its supply chains, forcing market gate prices lower and lower. It was not just the farmers, butchers, green grocers, independent liquor store and service stations that suffered, and largely disappeared, Coles was hit for six. The rival (as yet not acquired by Wesfarmers) tried to mimic Woolies as best it could, but soon hit the ground and continued to bruise as Woolies continued to kick and kick.

Things are a little different post-GFC and new market initiatives are thin on the ground for the supermarkets. Coles may have posted a faster growth rate than Woolies since being acquired by Wesfarmers but only from a much lower base. Woolies is still a force. Metcash ((MTS)) is fiddling around at the periphery but genuine competition is now being offered by foreign competitors such as Aldi and Costco.

The Coles recovery now appears to have all but run its course and let's not forget, Wesfarmers includes consumer discretionary, insurance and resource sector divisions.

Add it all up, and five of the seven FNArena database brokers covering Wesfarmers cannot justify a 20x multiple. UBS is at least prepared to hang at Neutral, while all of Deutsche, CIMB, Macquarie and Citi have ascribed Sell or equivalent ratings. Credit Suisse (Outperform) is a bit of a lonely bull, while BA-Merrill Lynch (Buy) admits retailing remains subdued and thus it's becoming harder to feel confident in forecasts.

But there's that yield. As we've seen with the banks, analyst claims of overblown multiples is not an impediment to further price rises in a yield-hungry world. We may be about to learn, nevertheless, that the earnings outlook for the banks is finally improving. The earnings outlook for Wesfarmers seems less encouraging.

The FNArena database shows a consensus target of $41.62 for WES, or 1% below Friday's closing price. One should not expect too wide a target range for the conglomerate, but we see Citi the low market down at $34.60 and Merrills the most exuberant at $53.00.

Funny. Merrills was so critical of the company's decision to acquire Coles back in the day.