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Wesfarmers primed for growth

There is a lot to like about the West Australian-based Wesfarmers (ASX: WES), not least of which is the shareholder oriented management, which is a defining element of the company’s culture.

While many management teams try to ‘dress up’ results and focus on whatever number looks the best, beware of management teams who like to talk about earnings before interest, tax, depreciation and management (EBITDA). Wesfarmers digs into numbers which really matter to shareholders such as return on capital, return on equity and cash flow.

More upside potential than downside risk?

At each results presentation, Wesfarmers includes details of divisional returns on capital. A look at recent past performance suggests there is substantial room for improvement, which bodes well for shareholders.

With the exception of the resource division, which is exposed to the price of coal and has the potential to damage Wesfarmers’ overall earnings, many of the other divisions have a reasonable chance of improving their returns from what in some cases were weak financial year (FY) 2012 levels. For example the Insurance division and Officeworks earned returns of 0.4% and 7% respectively on their capital in FY 2012. For the half year to December 2012, however, these returns improved to 6.6% and 7.5%, which is still low but heading in the right direction at least.

In the case of the Insurance division, its exposure to the 2011 Christchurch earthquake affected earnings by $125 million in FY 2012, hence the 0.4% return on capital. At the company’s recent Strategy Day presentation, the trading update stated that there had been a “strong performance year to date” in underwriting.

Meanwhile, consider that Kmart is earning a 22.5% return on capital. If management can boost its other retailing divisions, including Officeworks and Target, towards Kmart’s returns, then shareholders stand to benefit greatly.

Valuation

Adjusted earnings per share (EPS) in 2012 were 183.9 cents. According to Morningstar, Wesfarmers is forecast to earn EPS of 198.6 cents for FY 2013 and 219.1 cents in FY 2014. These forecasts suggest a growth rate of 7.9% and 10.3% respectively. For such a large company (Wesfarmers has a market capitalisation of around $40 billion) with significant market share in many of its business units, these rates of growth are impressive. Based on Morningstar’s forecast, at today’s share price of $39.20, Wesfarmers is trading on a FY 2014 price-to-earnings ratio of 17.9, which is arguably not demanding given the scope to continue to boost returns on capital.

Foolish takeaway

Owning companies where management isn’t acting in the interests of shareholders is a recipe for disaster. Identifying high quality management teams and then waiting patiently for an appealing purchase price is a sound way to build long-term wealth. Other companies with shareholder-oriented management teams that could be well worth investors having on their watchlists include travel agent Flight Centre (ASX: FLT) and plumbing supplier Reece Australia (ASX: REH).

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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