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Wesfarmers Exits Homebase, Where Next?

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Wesfarmers ((WES)) has bitten the bullet, deciding to withdraw from its Bunnings experiment in the UK and Ireland. The company had witnessed some encouraging signs in recent trading as the weather improved but the opportunity, albeit material, did not justify additional capital or management's time.

The Homebase acquisition, which underpinned the Bunnings move after which stores were in the process of being re-branded Bunnings, is being sold to Hilco Capital, a UK-based restructuring and refinancing company.

Hilco will acquire the Homebase brand, store network, property, leases and inventory for a nominal amount. The 24 Bunnings pilot stores will revert back to the Homebase brand following completion of the transaction, expected to close June 30.

Wesfarmers will participate in a value share mechanism whereby it will be entitled to 20% of any equity proceeds on further sale by Hilco indefinitely, and will record a loss of -GBP200-230m at the FY18 result.

While Citi considers such an earnings contribution is unlikely in the near term, the important aspect is the indefinite nature of the equity agreement as this presents earnings upside for Wesfarmers, should Hilco be successful in turning the business around in the long-term.

The move on Homebase was considered a risky decision by brokers in the first place and now that risk is removed from the stock the balance sheet is enhanced. Citi did not expect a buyer would acquire the full lease liabilities (disclosed at GBP1bn), which indicates Homebase may be run as a going concern in the UK.

Ord Minnett calculates the investment eroded shareholder value for Wesfarmers to the tune of -GBP1.3bn, almost a year's worth of dividends, and notes the problems encountered in the UK were much a function of due diligence as well as execution, which the company acknowledges.

Therefore, Ord Minnett remains cautious about future offshore M&A, given Wesfarmers' mixed track record. The company maintains offshore ambitions yet the broker suspects any M&A will be treated with significant scepticism.

Outcome Better Than Expected

One positive emanating from the decision to sell is that the company has avoided significant closure costs. Ord Minnett had expected a -GBP631m exit cost and suggests the deal reflects well on the company's new business development team. Gearing metrics should also improve.

Deutsche Bank calculates that given the cited loss on disposal, and the business being written down to GBP150m in February, the exit costs appear to be around -GBP50-80m. These costs stem from working capital, contributions to the pension scheme and transaction costs.

The outcome is better than Credit Suisse had expected, noting a stronger focus on capital allocation. The broker upgrades earnings estimates by 5% across the forecast horizon to reflect the removal of the Bunnings UK & Ireland losses. The broker also upgrades estimates for dividends to reflect better cash flows.

Hence, Bunnings should now perform well following industry consolidation in Australasia and Coles, under new leadership, could leverage its undemanding comparables and margins to drive performance.

Where Next?

Cost savings have been achieved in the industrial divisions although Ord Minnett notes revenue growth remains difficult. Department stores are increasingly led by Kmart, while earnings ambitions for Target have been reduced. Nevertheless, the broker finds a lack of valuation support in the stock, maintaining a Hold rating.

UBS removes the Bunnings UK & Ireland venture from its estimates beyond FY18, driving a 3% upgrade to FY19 estimates for earnings per share. Beyond FY19 the impact is more muted, as the broker had previously forecast the losses would ease.

UBS considers Wesfarmers has a strong suite of businesses with market leading positions but the general outlook remains soft in the short to medium term, although few catalysts for underperformance are envisaged.

With a significant re-rating of the stock following decisions to de-merge Coles and divest Bunnings UK & Ireland, the market will likely search for sources of further upside and, organic expansion opportunities in industrial businesses exist, Credit Suisse believes, although these are not widely understood by the market.

Citi agrees the earnings profile of Wesfarmers has been re-shaped, following this latest divestment, the sale of the Curragh coal mine and plans to de-merge Coles, so the risk is reduced. Yet, the broker decides to downgrade to Sell from Neutral, following recent appreciation in the share price.

FNArena's database shows two Sell ratings, four Hold and one Buy (Credit Suisse). The consensus target is $42.94, suggesting -5.3% downside to the last share price. Targets range from $39.00 (Morgan Stanley) to $47.36 (Credit Suisse). The dividend yield on FY18 and FY19 forecasts is 4.8% and 5.0% respectively.

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