Shares of Wesfarmers Ltd (ASX: WES) are down 4.3% over the past 12 months.
That compares to a positive 4% return from the broader S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) and a 25% fall from key rival Woolworths Limited (ASX: WOW).
Whilst many of Woolworths' misfortunes are often traced back to poor managerial decisions, many analysts are forecasting a thinning of profit margins within the entire Australian supermarket sector, as competition grows.
Indeed, despite holding an estimated 74% grocery market share between them a rapidly-growing Aldi franchise and the introduction of Costco mean it's no longer a two-horse race between Coles and Woolworths.
Monitoring the grocery market is likely an important pastime for many Wesfarmers shareholders given the company derives such a large proportion of its profits from the Coles division.
The Coles division includes Supermarkets, Liquorland, Vintage Cellars, First Choice Liquor and Coles express.
Whilst Wesfarmers generates less profit from supermarkets than Woolworths, its margins are lower. In 2014, Wesfarmers' Coles division had a profit margin of 4.5% versus Woolworths' Australian Food, Liquor and Petrol's 7.0%.
So if Woolworths has already come under pressure to lower prices, how long will it be before Coles is also forced to lower its margins to maintain market share?
Of course, Wesfarmers may be better placed than Woolworths to offset slower growth in supermarkets due to its more diversified asset base.
Indeed, Bunnings Warehouse and Officeworks contribute 28% of profit and are ticking along nicely.
However, the Chemicals, Energy and Fertilisers; Resources; Industrial and Safety; and Target businesses continue to struggle.
In the 2014 financial year, these businesses produced a combined EBIT (earnings before interest and taxes) of $568 million. In the same period, Wesfarmers invested $486 million as capital expenditure.
Whilst overall group capital expenditure fell by $411 million between 2012 and 2014, personally I think it'd be safe to assume the company will continue to increase capital expenditures in the low-single digits over the next five years.
Are Wesfarmers shares overpriced?
Slower growth is not always a problem. However, slowing growth is more often than not a problem when your shares are very richly priced.
Wesfarmers shares trade on a price-earnings (P/E) ratio of 26x and at an enterprise value to EBITDA (earnings before interest, tax, depreciation and amortisation) multiple of 10.4x.
Woolworths shares trade on a P/E of 14x and at an EV/EBITDA multiple of 7.9x.
Based on my calculations, Wesfarmers shares trade at a significant premium to their theoretical, or intrinsic value estimate — which is around $32.00.
I might be a little bearish on Wesfarmers, but given that much of my portfolio is tied up in Woolworths shares, I think it's better to be safe than sorry.
As I wrote yesterday, Wesfarmers shares are — if I'm generous — a hold.
A better dividend stock idea than Wesfarmers
