Conglomerate Wesfarmers Ltd (ASX: WES) has come a long way in the past 10 years, and is now Australia's second-largest retailer.
The acquisition of Coles in 2007 was widely derided by the market as overpriced. At the time, Wesfarmers paid $22 billion for the Coles Group, which included Coles supermarkets and liquor business, Kmart, Target and Officeworks. It was also the largest corporate deal in Australia but scorned by investment banking analysts.
According to Fairfax Media, a Merrill Lynch analyst said, "We doubt whether Wesfarmers has the capability to turn this business around". Morgan Stanley commented, "Wesfarmers will bleed if it takes over Coles."
Interestingly, a private consortium that included Woolworths Limited (ASX: WOW) had also made a bid, with Woolworths reportedly considering offering $6 billion for Officeworks and either Target or Kmart.
Getting back to Wesfarmers, in 2006, the company generated an adjusted net profit of $1.05 billion on revenues of $8.9 billion. 42% of earnings came from coal while 31% came from Home improvement. Insurance, Industrial and safety, Chemicals and Fertilisers contributed an additional 9%, 7% and 6% respectively.
Current CEO Richard Goyder was appointed CEO and Managing Director in July 2005 and was responsible for the Coles acquisition and should be commended for the turnaround at the retailer.
The following chart shows how Coles was struggling prior to the acquisition.
In 2007, Coles had sales of $34.7 billion and made an underlying net profit of $792.4 million. The food & liquor business generated $20.4 billion in sales and had earnings before interest and tax (EBIT) of $693.3 million. By comparison, last year, the food & liquor business generated $29.2 billion in sales and $1,536 million in EBIT – more than double the 2006 earnings.
The following two tables shows how Wesfarmers has not only grown sales from the acquired Coles businesses, but has also stripped costs out.
| Revenue | 2006 | 2014 | Change |
| Food & Liquor | 20,437 | 29,220 | 43% |
| Coles Express (Convenience) | 5,793 | 8,171 | 41% |
| Kmart | 3,889 | 4,209 | 8% |
| Target | 3,306 | 3,501 | 6% |
| Officeworks | 1,262 | 1,575 | 25% |
| Total | 34,687 | 46,676 | 35% |
Source: Annual reports
| EBIT | 2006 | 2014 | Change |
| Food & Liquor | 693 | 1,536 | 122% |
| Coles Express (Convenience) | 45 | 136 | 200% |
| Kmart | 97 | 366 | 278% |
| Target | 290 | 86 | -70% |
| Officeworks | 85 | 103 | 21% |
| Total | 1,211 | 2,227 | 84% |
Source: Annual reports
Bounding Bunnings
Coles hasn't been the only success story in the Wesfarmers group. Bunnings has been powering along. From $4.9 billion in revenues in 2007, the Home improvement division generated $8.5 billion in sales last financial year, and now contributes 25% of earnings.
Missed Target
But not everything is as rosy as it appears from a quick glance. Wesfarmers has major issues with discount variety retailer Target, which it has struggled to turn around. You can see from the table above, EBIT has dropped 70% since 2006. Woolworths must be thankful they didn't pick it up in 2007
The problem is that Target seems to have lost its market position. It's neither a super-cheap retailer, nor a high-end aspirational retailer. Target also competes against Wesfarmers' own Kmart as well as Woolworths' Big-W, not to mention department store retailer Myer Holdings Limited (ASX: MYR), a host of offshore retailers that have arrived recently as well as a number of online-only retailers.
I'm not sure how Wesfarmers can resolve the current Target issues, and offloading the business may be the only option. By contrast, K-Mart is generating strong growth – five-year earnings compound growth of 27% and strong improvement in return on capital. It's nice to see a business focused on improving their returns on capital employed.
First Choice Liquor not so first choice
Media reports also suggest that Wesfarmers is struggling as much with its big-box liquor store First Choice, as Woolworths has with its Masters Home improvement rollout. 32 liquor stores have been closed in the past 12 months, and prices have been slashed across 300 of Liquorland's main products.
By comparison, Woolworths' Dan Murphy's continues to grow faster than First Choice and appears to have a lead First Choice will struggle to match.
Coal
Wesfarmers' Coal division has seen its contribution to group earnings slashed from around $885 million in 2009 to just $130 million last financial year. Wesfarmers strategy appears to be controlling costs and optimising mine production, with 'capital light' expansion.
Wesfarmers' two remaining divisions, Chemicals, Energy, & Fertilisers business and the Industrial & Safety division are in the process of restructuring, cutting costs and streamlining business. Further expansion of these businesses through small add-on acquisitions is likely, but they only contribute 9% of Wesfarmers' group earnings currently.
The insurance division has been steadily sold off over the past few years.
Foolish takeaway
While Wesfarmers is widely diversified, its primary two businesses, Coles Food & Liquor and Bunnings contribute 78% of earnings, both are growing strongly and will continue to be the main drivers of overall group performance. Diversification has served the company well over the years, and that appears set to continue.
At the current price of $41.63, Wesfarmers is trading on a prospective P/E ratio of around 19 times earnings and is paying a fully franked dividend yield of close to 5%. Given the quality of Coles and Bunnings, that appears to be a reasonable price for a high-quality business.
