Bigger is better for Wesfarmers
Listed@ASX Winter 2021
Wesfarmers ASX:WES
This successful industrial company finds its strength in diversification.
Rob Scott, CEO, Wesfarmers
Wesfarmers is an outlier among Australian listed corporations. It is a conglomerate that owns a mix of assets including four large and profitable retail businesses – Bunnings, Kmart, Target and Officeworks. It also has chemicals, energy and fertiliser operations, including a new foray into lithium mining, and a small industrial and safety division. And let’s not forget a long-held stake in boutique investment and wealth planning group, Gresham Partners. It is sitting on a handy net cash position, by now likely to be well in excess of $1 billion. Its 2020 December half year results revealed a kitty of $871 million. That came thanks to strong operating cash flows through COVID and the sale of a further interest in Coles after it was spun off in 2018 as an independent ASX listing. The 2020 recession has left very few marks on this fit and eager top-10 company.
There is a view in investment circles the best thing for such conglomerates is to bust them up. The theory is the sum of the parts is nearly always greater than the whole. The idea is shareholders can extract more value when they invest in companies that focus on a single core competency – be it retailing, finance, mining, energy or something else.
Wesfarmers is in all five. If it was to be dismantled today, it would be easy to see how it could spawn a dozen or so solid and independent businesses, just as it did when it floated supermarket chain Coles. In its current form, its reach could be extended into new fields of endeavour based, if nothing else, on its substantial financial reserves.
CEO Rob Scott makes no excuses for deliberately being an odd one out. “Our core purpose is to deliver a satisfactory return for shareholders, and we do that in a number of ways,” he explains. “We operate our businesses to the best of our abilities and invest in new growth opportunities and in adjacencies as well as new businesses. We are very disciplined from a capital allocation point of view. We only invest when we think it will ultimately deliver improved returns.
“Around the world conglomerates are gaining the benefits that we see by giving their operating divisions a high degree of autonomy and allowing teams to make decisions closer to the customer, closer to the business. It often leads to better business decisions.
“Another advantage of such a portfolio is having the optionality and the flexibility to adjust the allocation of capital over time. As we know, markets are dynamic. Industries change. When you think about Wesfarmers, one of the keys of success in delivering superior total shareholder returns is that we have continued to evolve and adapt and change the places in which our capital is allocated.
“A great example of that was, when we IPO-ed in 1984, our fertiliser business accounted for about 60 per cent of our earnings. Today, it accounts for about one per cent. If we had defined ourselves in a very narrow way as a rural or fertiliser business, clearly we would have missed many opportunities over the last couple of decades. So, I think that flexibility around how you allocate your capital, allowing management teams to make decisions close to the customer, close to the business, drives good outcomes.”
Despite ongoing changes in its make-up, Wesfarmers’ business portfolio today still has some clear resemblance to its early days. It was formed in 1914 as a co-op to help farmers in Western Australia to grow and market their produce. There was an underlying theme that it should help rural communities to prosper, not just their customers on the land. That took it into a broad range of services including finance, transport and mining. It became a public company in 1984, and soon after bought Gresham Partners, CSBP Fertilisers, its first shareholding in Bunnings, coal mines, rival rural supplier Dalgety Farmers, Westrail freight, Howard Smith shipping and some financial services and gas businesses. The deals came frequently, and often went back in one way or another to its deep connections in the rural sector.
Scott has an explanation. “The history of Wesfarmers has been trying. This applies to both when we were a co-operative, and also as a listed company. It’s about solving problems and meeting the needs of industry and the community. Whether we go back to the early days of developing our fertiliser business or the LPG investment we made when we invested in the Kleenheat gas business, it was all about solving problems for industry in Western Australia. With the development of Bunnings, we initially invested in a forestry and timber business. But, over the years, the hardware and home improvement side developed. Then we saw an opportunity in 1994 to reimagine that business through the warehouse concept.”
Wesfarmers’ performance in recent times speaks to the success of this business model, although Scott admits not every investor likes it. “Conglomerates or diversified businesses have become less common, and sometimes they are more challenging for investors to understand. They have to do more work on the different businesses we are in. But, increasingly around the world, we are seeing the emergence of new conglomerates. You could argue Amazon is a conglomerate in its own right, as is Microsoft. It makes it more challenging for investors but, once they do understand it, often there can be strong alignment.”
There are a number of reasons investors knock on his door. “You may have an international investor that has an interest in Australia. When they are thinking about where should they invest here, they often quickly come to Wesfarmers as one of the top 10 listed companies. They see a good mix of defensive characteristics combined with growth. A good mix of dividend yield versus opportunity, and the strength of a number of our underlying businesses that are very well positioned in their respective markets.”
Management is rarely tempted to stray outside core strategy. “Our purpose is to deliver a satisfactory return for shareholders,” Scott explains. “We do that in a number of ways such as operating our businesses to the best of our abilities and investing in new growth initiatives.
But we are very disciplined from a capital allocation point of view. We only invest if we think it will ultimately deliver improved returns.
“I think it’s also important that, if you want to create long term value, you operate in a sustainable way. Having a strong balance sheet gives us the capacity to invest for the long term. It gives us the ability to be opportunistic from an investment point of view, should opportunities arise. Finally, given the uncertainty and volatility we’ve seen in the market with COVID, it just gives us greater flexibility to withstand external shocks that come along from time to time.
"Having a strong balance sheet gives us the capacity to invest for the long term. It gives us the ability to be opportunistic from an investment point of view."
“It’s hard to predict what we’ll do from an M&A point of view in the next 12 months,” Scott explains. “But we are conscious that one of the best ways a company can destroy shareholder value is by setting out to do an acquisition for the sake of doing an acquisition. The only deals we want are ones that add value for shareholders. I can’t say without knowing what the opportunity is, whether we will invest or not. What I do know is there’s plenty of opportunities to keep investing in our existing businesses. The way we think about it is that we are not more likely to do them because we have a strong balance sheet. We’re not constrained by capital, we’re constrained by the quality of the opportunities. So, if we have surplus capital, we’ve also demonstrated over the years we’re not afraid to give that back to our shareholders in the most tax-effective way. But, it’s often during the tougher times when some of the best opportunities come up.
“We’re feeling increasingly confident about the next 12 months as a result of the successful way Australia has responded to COVID. The vaccine is rolling out, we’ve seen unemployment reduce materially and the economy is in pretty good shape. But the caveat is there’s always a risk of further changes and uncertainties with COVID. We’re certainly not out of the woods yet. There are many risks, but we’re feeling a lot more confident now than we did six months ago.”
There is some indication based on the company’s recent share price performance investors do expect to be rewarded. Many remain cautious, however, about quantifying their expectations. Stockbroker forecasts indicate they don’t expect the stellar $2-per-share interim dividend paid pre-COVID in early 2019 to be matched for some time. It is encouraging, however, the final half dividend payment last year of 95 cents was higher than the previous payment of 78 cents. So too was the recent interim dividend of 88 cents. Morningstar Data’s current average earnings for the business forecasts only very modest rises, however, from $1.987-per-share last year to $2.091 in the current period.
Clearly, the company is moving forward thanks to the economic recovery, particularly given the up-beat property cycle exposure with Bunnings and growth in sales at Kmart and Target. Bullish stockbrokers are estimating earnings-per-share could rise by more than 18 per cent in the 2020-21 financial year as revenues top the $34 billion mark. That may have provided the impetus behind the share price rise early this year above $55, a new record.
Unlike many other leading listed companies, Wesfarmers has made few offshore investments. “We do look at opportunities offshore from time to time, but they need to stack up financially,” Scott states. “On one hand, there’s an attraction if you’re accessing bigger markets and diversifying your current portfolio. But, on the other hand, you sometimes have greater risks when you’re moving into new markets. It comes back to the quality of the opportunity. We have hundreds of our team based in Asia, particularly in retail and sourcing roles. We already have a lot of capability there, and we’re continuing to invest in our team. We have very significant product development capabilities that sit as part of our broader Kmart group, so offshore markets are important to us, as it relates to sourcing markets. But you may not be as experienced with respect to the different regulations, different customs and so forth. There are different risks.”
Its internal business development capabilities are being applied right now in two distinctly disparate areas, retail and lithium mining. The Mt Holland lithium mine and associated processing development is driven by soaring demand for a mineral that is essential for the batteries that power electric vehicles. The second opportunity, Catch, is an e-commerce marketplace which captures a considerable depth of group experience in sourcing retail products to be sold through a new channel. Scott cites these two as being high-level trends in which Wesfarmers has deep and relevant capabilities. In retail, it already has digital sales channels, and with lithium there is development and manufacturing expertise within the fertiliser arm. He says there were a number of reasons that gave it the confidence to pursue both opportunities.
“We’re always looking for ways to improve and build on the performance of our existing businesses.”
Scott stresses, however, these investments will take time to bear fruit. “There has been a degree of speculative demand and interest in both areas. I must stress, it is much more around the long-term prospects. We were also very focused on areas in which we had a competitive advantage. We’re always looking for ways to improve and build on the performance of our existing businesses. If I think about the lithium opportunity and Catch, they came about from both a bottom up and a top down approach. The trends and the opportunities were top-down. It just so happened we had some deep and relevant capabilities in our existing businesses. We already have quite sophisticated digital capabilities in our retail businesses and very deep manufacturing and development capabilities in our chemicals business that are very relevant to the lithium opportunity.
“Mt Holland, however, isn’t just about lithium. It is about investing in one of the lowest-cost resources on the planet, and then leveraging some unique chemical manufacturing and development capabilities we have in Western Australia. In this case, it makes sense for us to partner with SQM, a global leader in lithium hydroxide. It’s a really good combination.” Projections for lithium’s use are very strong, as electric vehicles quickly reshape vehicle markets in Europe, China and the US.
Asked whether Wesfarmers would be happy to retain a half interest in the lithium venture, Scott responded: “Well, in many cases, we have a preference for 100 per cent control. You have the benefit of having full access to the cash flows and also management control. In some cases, partnering with others does make sense. If you go back over the longer term, we initially invested in Bunnings with a 10 per cent stake, then that grew to a 46 per cent stake. So, there may be some occasions when 50 per cent ownership or less makes sense. But there needs to be a strong logic around it.”
The growth in lithium-ion battery sales is soaring around the world as costs have fallen. Energy transition research group BloombergNEF recently reported in its 2021 Executive Factbook battery costs had sharply fallen over the last 11 years, from $US1,191 in 2010 to $US137 in 2020. It also reported passenger electric vehicle sales rose by more than 28 per cent in 2020 even as the largest single market, China, weakened. Sales in Europe more than doubled to 1.1 million vehicles to overtake China as the world’s largest seller of electric vehicles.
The purchase of Catch is seen by the company as a business that can succeed despite other owners having failed. “The acquisition of that marketplace, a year and a half ago, was a great example of an interesting opportunity in its own right,” Scott explains. “But we can leverage the digital capabilities across the rest of our group, so we’re investing heavily in that.
“These investments are not going to pay back in the next year, but they could be quite transformative over the next five to 10 years. Those are elements for which it’s important for there to be an alignment between investors and ourselves. Shareholders that are prepared to take a longer-term view around delivering superior investment returns will be more orientated towards us. They will be aligned with the longer-term investment we’re making in our businesses.
Scott explains that, at a group level, Wesfarmers is quite tough on capital allocation. “The two most important roles in my job are capital allocation decisions and who we get to run our businesses. We have a corporate team that evaluates new opportunities, provides a lot of corporate functions and undertakes financing for the group. There’s also a lot of specialist capabilities such as investor relations, corporate affairs, legal, treasury and so forth. And these are areas where there is a logical group synergy.
“Coming back to one of the values of our operating model, we shield our operating businesses from the distraction around governance, disclosure and dealing with capital markets. They are important, but don’t add a lot to the day to day performance of our businesses. Clearly, we also have very important obligations around continuous disclosure, which our investor relations team runs. We also adopt more of a group approach with ESG, which is critical to our corporate reputation. With that, we also rely on our divisions to implement changes or initiatives that are relevant for their businesses.”
Scott sees a clear competitive advantage in limiting the time operating divisions are required to focus on activities outside of their direct business responsibilities. “That is a real competitive advantage that we can bring. If you’re in the management team at Bunnings, 99 per cent of your time is focused on making Bunnings as successful as possible. That involves both financial success and ESG success. Then, we at the corporate level deal with a lot of the broader investor communication and stakeholder management. We do that on issues to do with ESG because we believe it’s really important for the future financial success and sustainability of our businesses. Frankly, communication is relatively easy because we’re telling a story that is fully aligned with our business strategy. Sometimes the management of these issues can become far more demanding for companies and boards that may not have focused enough effort in these areas. But thinking about our chairman’s roadshow, there’s no doubt the focus on ESG and remuneration has increased significantly over recent years.
“Wesfarmer’s was one of the first companies to release what, at the time, was called a sustainability report. What looked good 22 years ago is very different to what it looks like today. The world has changed, our businesses have changed, the risks have changed, so it’s been important for us to evolve our approach. The importance of a number of these issues to the success of our business has increased. And, the expectations of not just our investors but broader stakeholders have also increased. On top of that, there are various additional reporting and regulatory obligations, be it the Task Force on Climate-related Financial Disclosures around emissions, carbon, climate change, the Modern Slavery Act and the obligations there, just to name two areas that require a greater degree of disclosure and governance.
No article today about Wesfarmers or any business is complete without reference to COVID. The company has experienced a boost from its supermarkets, specialist and department stores as Australians have been forced into lockdowns. The images of bare shelves as panic buyers grabbed essentials such as toilet rolls, pasta, meat and other consumables will stay in our minds for a long time. But, looking ahead, Scott doesn’t expect the strong sales in Wesfarmers’ retail brands will change any time soon even as Australia slowly emerges from the restrictions of the pandemic.
“People will continue to take a greater focus and sense of pride in their home environment, both for entertaining and also for work. Some of those trends are quite favourable given the nature of our retail businesses.”
“We don’t expect to see much in the way of international travel over the next 12 months. The recent COVID cases in Queensland and NSW are another timely reminder there are going to be further outbreaks. The vaccine rollout will take most of this year to get through, so we will be living with this for some time to come. Working from home, the move towards digital platforms and online shopping will persist. People will continue to take a greater focus and sense of pride in their home environment, both for entertaining and also for work. Some of those trends are quite favourable given the nature of our retail businesses.
“Like most other retailers, we’re coming up to the one-year anniversary of the peak sales we saw in the early days of the pandemic. But, overall, the trends of less international travel, less domestic travel, the stimulus on household budgets, the investments people are making in their homes are favourable for a number of our businesses like Bunnings, Kmart and Officeworks.”
It is fair to say the short-term prospects across the retail sector are not uniform. In its latest review of consumers and retail, Goldman Sachs concluded the year ahead would be volatile, while supermarkets would likely remain resilient. However, it expects any impact to be felt hardest by retailers that specialise in consumer cyclicals. It continues to rate Wesfarmers as a buy for investors. The emerging risk over the next two to three years will be the combined impact from lower population growth and the gradual unwinding of spending trends as international travel again becomes available. Stronger balance sheets have put the sector on a more secure footing however the prospect of a materially-weaker, long-term earnings outlook could mean capital management takes the form of higher dividends more than off-market buybacks. Time will tell.
A pragmatic approach to investor relations
Rob Scott takes a philosophical view of shareholder engagement. “At the end of the day, shareholders will decide whether they like us or not. There are some investor relations people who go out there and try to convince investors why they should buy their company’s shares. That’s not really our job. Our strategy involves communicating what we’re doing in our businesses. At the end of the day, investors will decide whether they like us or not.”
What Scott is implying is his investor relations strategy is geared for the long term. It can take years to win support from large institutions. While they all receive sales spiels from hundreds of eager companies, winning trust is a long game. Wesfarmers’ share register is roughly divided half into retail investors and the other half is evenly split between domestic institutions and international institutions.
Scott believes that spread works well because the large chunk of shares held by retail shareholders tends to be stable. Those people have a long-term perspective on the business. That gives him a very stable base from which to develop a plan for the
larger players.
“We didn’t necessarily start off with a strategy to diversify our shareholder base,” he explains. “Our approach is really to use investor relations as a way of meeting our continuous disclosure obligations. We communicate our purpose, our strategy, what we’re doing in our businesses and investors will decide whether they like it or not.
“Our job is to communicate clearly what we’re doing and, if an investor wants to invest in us, well great. International shareholders are an important segment on the register. Historically, we’ve undertaken annual international roadshows, most of them through the US, London and Asia. Over the last year, as you’d expect, that has all been through
video conferencing.
“When speaking to many international investors, the big difference we find is they may not know who we are. Sometimes, we have to start from first principles to explain ourselves. There are, obviously, more sophisticated and informed international institutions, and we like to engage with them where there’s an alignment between how they think about investment returns and how we think about investment returns. At the end of the day, some international investors may invest in Australia because of their view of the macro economy, or for diversification purposes. If they want to invest in Wesfarmers for those reasons, so be it. But, I guess we’re more interested in finding those investors who find an alignment with what we’re doing and are interested in being a longer-term holder.”
There are a number of reasons new investors are attracted to the business. “What is important is our long-term investment horizon. You often end up with the investors you deserve. Ideally, if you stay true to your strategy, you keep communicating relentlessly, and you successfully deliver on it, then your register will reflect shareholders that are aligned to your business. That’s very much our focus. They will be the ones that also put a high value on ESG credentials, because they will be aligned with the longer-term investments we are making in our businesses.”
It often starts with investors that already have an attraction to Australia. “When they think about where should they invest in Australia, they often quickly come to Wesfarmers as one of the top 10 listed companies. I guess they see a good mix of defensive characteristics, combined with growth. A good mix of dividend yield versus growth opportunity, and the strength of our underlying businesses, whether it be Bunnings, Kmart, or our chemicals, energy & fertiliser business. They are very well positioned in their respective markets.”
Scott says there are many comparisons offshore investors can make. “They compare us with businesses like [US homewares retailer] Home Depot, given its likeness to Bunnings. A company like Primark, a retailer owned by Associated British Foods, is sometimes a good comparison to Kmart. Our chemicals business is unique because it is a combination of chemicals, fertiliser and energy. That is a harder one to compare. Some have said that we’re a bit of a mini Berkshire Hathaway in that we’re a diversified conglomerate. One of the differences is that most of our businesses are 100 per cent-owned, whereas increasingly Berkshire is taking portfolio stakes in its investments.”
It should also be said Scott adopts a different approach to investor relations than some other companies. “We don’t go out and hire professional investor relations people. We generally use it as a talent development role. We often get some of our high potential commercial analysts and business development managers to spend time in investor relations. That gives them a fantastic insight into all of our businesses; fantastic exposure to investors and the capital markets. Then, they go on after a few years and do bigger, better things around the group. That’s served us really well because it is an important function and provides a great training ground for executives.”
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