Last week, Merrill Lynch analysts gave Woolworths a mauling over its strategy, yesterday it was the turn of Wesfarmers to cop a blast.
In a client note, Merrills said Wesfarmers was “unlikely” to turn around the performance of its Coles unit because of increased spending by Woolies.
Merrill Lynch dropped its recommendation on Wesfarmers to “underperform” from “neutral".
The firm last week cut Woolworths to "neutral" from "buy", citing the retailer’s plans to spend $2 billion annually for “a number of years” to convert stores to a new format and extend its lead over Coles. Woolies is also spending heavily in New Zealand.
“In our view, the Australian retail industry isn’t large enough to justify the levels of capital that Woolworths is planning to spend,” Merrills said in the report.
“Given the planned actions of a major competitor that could, in our view, prove detrimental to industry returns, we think a Coles turnaround is unlikely.”
"Given Woolworths’ future capex increases are focused on market share gains and not productivity, we think Coles earnings recovery could be materially hindered,” Merrills said.
"We believe the acquisition of Coles Group is expected to cause Wesfarmers to underperform for many years as it is expected to be more costly and take longer to turn around than both the market and the company anticipate.
"Other challenges the company is likely to face in the medium term are falling coal prices, a consumer slow down in conjunction with a higher cost environment, and debt refinancing risk.
"After Wesfarmers eliminated any balance sheet risk from its 3 for 7 rights issue and A$900m direct placement, we upgraded our investment opinion on Wesfarmers from Underperform to Neutral.
"We commented that we viewed the equity raising positively as well as management’s strategy.
"Unfortunately for Wesfarmers, its major competitor (Woolworths) looks to be raising the pressure.
"We are concerned that Woolworths has upped the ante in capital spending on its stores, even potentially putting its own returns at risk, in order to strategically disadvantage its competition – namely Coles.
"In our view, the Australian retail industry isn’t large enough to justify the levels of capital that Woolworths is planning to spend.
"We think it could result in not only reduced returns for itself, but also for its competitors. Coles is a key division of Wesfarmers, and its turnaround is critical.
"Given the planned actions of a major competitor that could, in our view, prove detrimental to industry returns, we think a Coles’ turnaround is unlikely."
But Wesfarmers is more than Coles: its other retailing arm is Bunnings, the home improvement/hardware chain, it has insurance and financial services, industrial services and gases and coal where prices for the 2009-10 contract year in Asia look like being down 40% at least.
Merrill’s pointed that out in yesterday’s note, saying:
"Coal prices have settled at around US$125 for Hard Coking, US$90 for LV PCI (Pulverised Coal Injection) and $US70 for Thermal.
"However, volumes is not known, and they could be materially lower in FY10 and FY11 than in FY09. We have reduced our coal volume assumptions for Curragh to around 6 million tonnes (mt) for FY10E and FY11E (previously 6.6-6.9mt), leading us to forecast FY10 EBIT for Coal at -$4m.
"Including the recent share allocation, our forecast EPS for FY10 has been reduced from $1.03/shr to $0.966/shr (-5.9%) and from $1.29/shr to $1.14/shr (-11.5%) for FY11.
"We lower our recommendation to Underperform with a revised valuation."
Here’s what Merrills said last week about Woolies
Woolworths current investment strategies concern us We have had a BUY on Woolworths because of its capability to generate cash flow and increase its return on investment. We saw the next 2-3 years as being extremely lucrative for shareholders – with large dividends and capital returns.
However, the current strategic direction being undertaken by the company is putting our investment thesis (increasing shareholder returns) at risk.
What concerns us is the level of capital Woolworths is currently spending. Given the current state of Woolworths’ businesses and the current economic outlook, we believe that WOW could reduce its capex over the coming 2 to 3 years, maintain its earnings growth, and undertake capital management to increase s/h returns.
We are concerned that Woolworths is currently too focused on improving its underlying business from a customer standpoint and strategically disadvantaging its competitor – and not enough from its own shareholder standpoint.
Woolworths is well placed to achieve strong earnings growth over the next few years – although we now believe that it will be spending excess capex to achieve it.
We believe continued reinvestment in its store network and price will further drive sales growth and widen the performance gap relative to its competitors – but at too great a cost to returns on investment.
Woolworths is in a commanding position, and is an outstanding retailer.
However, returns look like they a re being neglected.
What concerns us is the level of capital Woolworths is spending to achieve such growth ($2bn pa for a number of years)…and the underlying reasons it appears to be spending the capital for.
We are somewhat concerned that Woolworths is spending the capital more for its customers and to keep a c
