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 What price Wesfarmers? - Eureka Report article 

September 8, 2008

 

What price Wesfarmers?
By Scott Francis

 

PORTFOLIO POINT: Depending on the research, the true value of Wesfarmers shares is above $46 or below $23. The market says $31, which seems fair.

Westpac research says $46.85, the current share price is $30.90, and a recent Eureka Report article argues that they are worth $23. So the question is: are Wesfarmers shares 25% overpriced, 50% underpriced or somewhere in between? I guess that it all just goes to show why no one said that investing was easy .

I have always regarded Wesfarmers very highly. During my time studying business at university, it was a company that was often promoted as having a strong model that built internal leadership and did a great jot of managing leadership succession. It also had a rigorous approach to the financial performance of each business unit and a willingness to make rational decisions to buy and sell businesses based on financial performance hurdles. It remains the key survivor of the "diversified conglomerate" trend of the 1980s.

This stands in contrast to others of the "diversified conglomerate" companies such as Pacific Dunlop, where splitting off businesses such as Pacific Brands, Repco and Cochlear, rather than keeping them in-house, seems to have created shareholder value. Some may say that Wesfarmers has some similarities to Berkshire Hathaway, arguing that it has a similar financial discipline built around acquiring businesses at reasonable prices (think of the time it took for Wesfarmers to make a bid for Howard Smith group and Bunnings) and a healthy focus on "reasonable" shareholder returns. Of course, others will suggest it is treason to suggest such comparisons.

I take it from the letters that followed Roger Montgomery's feature (see Is Wesfarmers overpriced?), in which he suggested a valuation of $23, that Wesfarmers has attracted a number of supporters among Eureka Report's subscribers. However, it is worth mentioning that the average total shareholder return (increase in share price and dividends paid) for Wesfarmers for the five years to September 5, 2008, has been 11.4% a year, whereas the average market return over this period has been just over 14% a year.

An interesting sideline to this discussion of the "right price" for Wesfarmers is that it comes shortly after the ACCC inquiry into the competitiveness of the supermarket environment; it doesn't hurt to be shareholder in a company (Coles) where there is concern about your company having too much market power.

The dividend discount model

Many mathematical models have been proposed to give valuations of individual companies. I guess that in some ways this is the "holy grail" of portfolio theory: finding a way to understand the value of a company better than the other investors around.

The most useful definition of an investment that I have found is that the value of any investment is the present value of all future cash flows. For a share investment, that refers to the value of a (hopefully) growing stream of dividends received over time.

From the perspective of an individual investor, I think one of the best ways to understand the value of an investment is the "dividend discount model", perhaps the simplest model I have come across.

The model says that the;
Price of a share = (Dividend per share)/(Required return - Growth rate)

Let's have a look at some of the inputs for Wesfarmers:
  • The price at the time of writing is $31.
  • Let's assume that the required return to an investor is 11% a year: 7% above the inflation rate of 4%).
  • The current dividend is $2 a share (from the data I am using).

We can incorporate these inputs into the equation which shows:

31 = 2/(0.11 - g)

When we solve for g, the required growth rate, we find that growth in dividends of 4.5% a year is required to support a share price of $31.

The growth Wesfarmers needs

The question is: can Wesfarmers produce the ongoing 4.5% a year in dividend growth that is required?

The 10-year average annual increase in dividends for Wesfarmers has been 13.2% a year. Historically, Wesfarmers investors have received a much higher increase in dividends than the 4.5% a year.

One trend that investors would be wise to keep in mind is that this year dividends ($2) were actually higher than company earnings per share ($1.80), according to the latest Wesfarmers annual report. This is really important to be aware of, given the failure of many investments with "manufactured" yields. I am not suggesting any parallel between these failed investments and Wesfarmers, just that the best sort of dividend is paid entirely out of earnings, and Wesfarmers has not quite met that standard in the latest dividend. It does report that operational cash flow for this period was $2.47 per share.

Of course, if you could accurately forecast the earnings growth of companies you would be rich. I am not a rich person, and I also don't believe in the ability of the financial services industry to forecast accurately - so there is no reason that I should be commenting on the likelihood of Wesfarmers achieving a 4.5% dividend growth rate. However, the key issues will be:

Economic growth and inflation. If inflation runs at 3%, then it is pretty reasonable (as a broad brush assumption) to assume that most businesses will grow their earnings by at least this amount; that is, if both their revenue and costs grow at the rate of inflation. If economic growth grows at a rate greater than inflation, then the total of business earnings should be dragged along as well.

The way managers deploy capital. Return on equity measures how efficiently shareholder funds have been used. While Wesfarmers had a strong history of effectively deploying shareholder funds, this dropped rapidly this year with the huge amount of additional equity issued to purchase Coles. A lot of Wesfarmers' focus has been on the return that business units provide on the capital that they use. If they are successful in getting Coles providing a reasonable return on capital, then this goes along way to providing investors with a fair return.

Management of debt. Debt can work both for and against a company; well used debt in projects that provide a return higher than the cost of the debt will tend to create shareholder value. Wesfarmers now has significantly increased amounts of debt, something that poses a challenge for all companies in this "credit crunch" environment, and will require Wesfarmers to get the Coles investment providing a reasonable return to allow for the interest payments on the debt.

Strategy for and market power of Coles. Clearly the success of Wesfarmers going forward is very much tied to its ability to turn Coles around. Wesfarmers seems to have skills in managing the business units it has bought in the past, although Coles is likely to be its biggest challenge in this regard.

Conclusion

If we look at an investment in Wesfarmers as being an investment in an ongoing stream of growing dividends, then the answer as to whether it will live up to its current price of $31 would lie in the growth rate of those dividends: can Wesfarmers produce average dividend growth of 4.5% a year?

The case against would say that the drop-off in return on equity and the fact that this year's dividends are not covered by earnings.

The case for would say a 4.5% annual dividend growth rate is significantly less than the company's historical growth rate, that Wesfarmers has a strong record of prudently managing investors' capital and that, provided Wesfarmers shares in economic growth somewhat above the rate of inflation, then this target will be met.

Unfortunately, I know that my crystal ball doesn't work so I won't try and impose my verdict on anyone, except to say that all else being equal an annual dividend growth rate of 4.5% a year seems a realistic expectation.

Scott Francis' articles in the Eureka Report 

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