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Why I think the ‘new look’ Wesfarmers Ltd (ASX:WES) is a buy

Earlier this month the demerger of Wesfarmers Ltd (ASX: WES) and Coles Group Limited (ASX: COL) became official, with the Wesfarmers conglomerate retaining just 15% ownership of Coles Group and 50% of its Flybuys business.

Wesfarmers still owns a collection of quality retailers, including Bunnings Warehouse, Kmart, Target and Officeworks, as well as a range of industrial businesses.

I believe the demerger positions Wesfarmers for long-term success and creates a great opportunity for investors who want to gain exposure to the Australian retail sector.

What does this mean for Wesfarmers?

Wesfarmers will earn significantly lower revenues after parting ways with Coles Group, with the supermarket chain having generated nearly 60% of the conglomerate’s $66.9 billion revenue in FY18.

However, Wesfarmers will now be a higher margin and higher growth business, which is able to generate a superior return on capital for investors. In fact, a recent report commissioned by the company indicates that post-merger, the conglomerate’s FY18 EBIT (earnings before interest and tax) margins grow from 6.5% to 11.1%, while EBIT growth increases from 4.5% to 10.4%.

I also believe the demerger has come at a good time for Wesfarmers, as Coles supermarkets are facing significant industry headwinds including intense price competition from Woolworths and Aldi. This is likely to worsen when global hypermarket Kaufland enters the Australian market, with experts also believing that this could be the precursor to German discount supermarket Lidl coming to Australia.

Retail price deflation is one result of this rising competition, with Coles experiencing price deflation of 0.8% (excluding fresh and tobacco) last quarter, further squeezing the supermarket’s already tight margins.

Bunnings Warehouse performance is key

The conglomerate’s future performance will largely hinge on Bunnings Warehouse, which accounted for around 60% of Wesfarmers’ post-merger FY18 EBIT.

Bunnings Warehouse generated a record EBIT of $1.5 billion in FY18, up nearly 13% on FY17, although concern has been raised about how the hardware store will perform amidst a cooling housing market. Hardware sales are typically cyclical to the property market, achieving stronger earnings in periods of high housing turnover and housing construction because there is more demand for the building materials and tools that are used in the construction and renovation of homes.

However, the outlook may not be so bleak for Bunnings Warehouse, with a Goldman Sachs study finding that in addition to housing construction activity, household income is also a significant driver of home improvement earnings, a factor that has a positive outlook for the next 1-2 years.

Therefore, it is possible that homeowners could choose to invest some of their disposable income into renovating their homes, rather than selling their homes in the current market. This could explain why Bunnings Warehouse was able to generate record earnings in FY18, despite the housing downturn.

Foolish Takeaway

While the jury is out on the short to medium term outlook of Bunnings Warehouse, I’m optimistic that the hardware store will continue to perform strongly as it did in FY18.

I also believe that irrespective of short-term cyclicality, Wesfarmers has a very positive long-term outlook, with its quality portfolio of consumer-favourite retail brands, including Bunnings, Kmart, Target and Officeworks, as well as its range of industrial businesses.

If you want broad exposure to the Australian retail landscape, now could be a good time to buy Wesfarmers shares, which I believe is a superior investment to Woolworths Group Ltd  (ASX: WOW).

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Motley Fool contributor Gregory Burke has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. The Motley Fool Australia owns shares of COLESGROUP DEF SET. 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 Scott Phillips.

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