If you sell Wesfarmers Ltd now, you might regret it

Credit: lee bristol

Since the start of the year, shares in conglomerate Wesfarmers Ltd (ASX: WES) have fallen by 2%. This is a worse performance than the ASX, which is up by 3% during the same time period. This could cause investors in the company to fear that further declines lie ahead.

Efficient capital allocation

In my view, Wesfarmers’ apportionment of capex is relatively efficient. It continues to direct the bulk of its capex towards its retail operation and with returns from the likes of Coles and Bunnings being higher than for Wesfarmers’ industrial companies at 29.7% and 45.8% respectively, I feel that the long term future of the company is bright.

By investing in customer service and store appearance in its retail operations, Wesfarmers is likely to better differentiate itself from no-frills operators, develop greater customer loyalty and stem the flow of shoppers to discount stores. This should help protect it from the continued threat from low cost operators such as Aldi. Further, with Wesfarmers’ industrial segment offering falling profitability despite excellent cost control and the generation of efficiencies through a major restructuring, the $2.2 billion spent on capex appears to be being spent wisely.

UK strategy

However, I’m less positive about Wesfarmers’ plans to spend over $1 billion on a restructure of recently acquired Homebase in addition to the $705 million spent on the acquisition. Due to the UK market being fragmented, I believe that Wesfarmers will find it difficult to dominate the market as it has done via Bunnings, where it has built a near-20% market share.

On top of this, Wesfarmers’ investment in the UK is now likely to be subject to a negative currency impact, with the value of sterling versus the Aussie dollar declining by over 10% since the EU referendum on 23 June. In my view there is a danger that its venture works out in a similar vein to Woolworths Limited’s (ASX: WOW) acquisition of Masters.

Dividend prospects

Investors may be concerned that Wesfarmers will be unable to sustain the dividend increases of 12.2% per annum which have been recorded over the last five years. In fact, some analysts are forecasting that Wesfarmers may cut dividends by 12.5% in the current financial year, which may lead investors to buy other higher yielding stocks such as Scentre Group Ltd (ASX: SCG).

Despite this, Wesfarmers has excellent cash flow, with free cash flow averaging $1.27 billion over the last two years. This indicates that dividend rises in the long run are likely and with Wesfarmers having a net debt to equity ratio of only 23%, it indicates that leverage can be used to develop the business further.

An improving outlook?

The latest retail turnover data from the ABS showed that the food retailing industry recorded a seasonally adjusted rise of 0.7%. Therefore, Wesfarmers’ retail outlook could be better than the market expects, although problems seem likely in its newly acquired UK operations and its industrial segment.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. 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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