If you're talking about investing in a blue-chip retail business, you can't mention Wesfarmers Ltd (ASX: WES) without so much as acknowledging its key rival, Woolworths Limited (ASX: WOW).
They have many similarities…
The Coles business accounts for a majority of Wesfarmers' sales, whilst Woolworths supermarkets also make up the biggest chunk of its sales and profits.
They both have large merchandising brands, such as Kmart, Target, and Big W.
They also have exposure to home improvement.
Service stations, liquor outlets…the list goes on.
However, despite their similarities Wesfarmers' share price has fared significantly better than Woolworths over the past year.
Whilst it too has fallen 4.4%, compared to the S&P/ASX 200's (Index: ^AXJO) (ASX: XJO) return of 3.02%, Woolworths is down a whopping 24% over the same period.
3 reasons Wesfarmers is a not a buy right now
Despite its relative outperformance, however, here are three reasons why I think Wesfarmers is a hold, at best.
- Supermarkets. Woolworths' share price has fallen hard in recent times because investors have grown concerned it may be losing the ongoing price war between it and Coles. The introduction of discount grocery retailer, Aldi, is also a big concern. For consumers, Coles may be slightly cheaper for now, but Wesfarmers' valuation won't hold up if the supermarket is forced to lower margins to retain market share.
- Non-core businesses. It's not just Wesfarmers' supermarkets which are under pressure. Wesfarmers, 'Resources; Target; and Chemicals, Energy and Fertilisers' divisions each produced lower profits in the 2014 financial year, before corporate costs and other items. Over the past four years, in fact, by my calculations, Wesfarmers has invested $2.036 billion in the three divisions for an EBIT (earnings before interest and tax) of around $2.843 billion. Each of these businesses could need significant investment in the near future to maintain their competitive edge.
- Valuation. Based on my discounted cash flow valuation, Wesfarmers shares are worth significantly less than the current market price of $40.19. In my opinion, investors shouldn't look to add Wesfarmers shares to their portfolio unless they traded well below $32.
I may be a bit bearish on Wesfarmers at the moment, and it could well go on to outperform the market over the next three to five years.
However, I think prudent value investors should place Wesfarmers on their watchlist and look for other cheaper stock ideas to add to their portfolios in the meantime.
