Is Wesfarmers Ltd profit under threat?

Wesfarmers Ltd (ASX: WES) could see its profit fall by 8% this year and the company will be forced to cut its dividend according to one analyst.

Bank of America Merrill Lynch (BAML) analyst David Errington says falling coal earnings, lower margins for its Kmart and Target stores and restructuring of Target and Industrial Supply divisions will negatively impact earnings.

Errington also says that Wesfarmers’ first half earnings were boosted by $251 million in advantageous currency hedging positions which are now coming to an end. He says this will hit Kmart’s margins. Errington is also against a proposed merger of Kmart and Target – as he says, “we believe a lack of trust between the two businesses could be prohibitive.”

Several Target executives were outed from CEO Stuart Machin down earlier this year after the company was rocked by reports of accounting shenanigans which artificially boosted profits. Kmart and Target have been combined into one division under the sole leadership of Kmart boss Guy Russo.

Errington is forecasting a 2016 financial year (FY16) profit of $2.2 billion, down 8% compared to the $2.4 billion in FY15. Earnings per share (EPS) are expected to fall from $2.16 to $1.98 and dividends to fall from $2.00 last year to $1.90 per share. Consensus estimates put EPS at $2.13 for FY16 and $2.35 for FY17 according to Reuters – equating to P/E ratios of 19.9x and 18x respectively at the current price of $42.38.

Coal losses of around $338 million will drag down performance too, and the analyst says the company may be forced to write down the asset values of Target and maybe Coal and Industrial Supply. Closing offices, exiting staff and rehiring could cost many hundreds of millions of dollars says Errington. The coal division reported a first-half loss of $118 million.

The analyst is also reportedly bullish about Wesfarmers rival Woolworths Limited (ASX: WOW) and is backing a revival of its supermarket business against Wesfarmers’ Coles, after dumping Masters, its CEO Grant O’Brien and believes a revival is fairly straight forward.

A revived Woolworths would also put additional pressure on Coles’ supermarkets.

Foolish takeaway

Discount variety (Kmart, Target and Big W) has been a problem category for both Wesfarmers and Woolworths for a number of years and it may be time for the companies to finally let go of them. Wesfarmers’ coal business is loss making and it may need to be jettisoned as well, or at least placed on care & maintenance to stop the money bleed.

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Motley Fool writer/analyst Mike King owns shares in Wesfarmers and Woolworths. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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