Wesfarmers reported modest EBIT growth of 3% in FY24 with low growth for Bunnings, a decline in WesCEF and strong rise in Kmart EBIT the notable factors. Bunnings earnings growth is likely to remain low over the next two years given limited store openings and a challenging demand backdrop. We think Kmart’s margins are near a peak, particularly given price competition with rivals is heating up. WesCEF and lithium become the key driver of Wesfarmers earnings from here and it will take up to three years to see meaningful earnings.

Wesfarmers held its annual strategy day and, as always, delivered a consistent message about its focus on long-term shareholder value creation.  The tone of Wesfarmers annual strategy presentation focused more on growth initiatives and highlighted the progress on productivity and technology investments. While a positive presentation, the detail is unlikely to change consensus earnings expectations and the share price remains very stretched.

Wesfarmers reported 1% sales growth and 2% EBIT growth for 1H24. The result revealed meaningful growth from Kmart and a large decline in WesCEF. Bunnings EBIT rose by 0.4%. The primary drivers of the result were improved gross profit margins and a tight control on costs given high underlying cost inflation. For WesCEF, reduced prices in ammonia and lithium will result in a difficult 2H24e. Kmart is at peak margins and ongoing cost pressures will limit margin expansion across retail in our view.

Wesfarmers’ strategy day highlighted its growth projects and market share opportunities, despite an increasingly challenging economic environment. The businesses may be relatively resilient, but they are not immune. The combination of slowing sales and rising operating costs keep us cautious.

There is much to debate about when retail sales slow, how far sales drop and how much margin downside will be associated with the sales weakness across the sector. We think the central driver of the debate is how quickly and far interest rates rise. In our base case (67% probability), the RBA reaches 2.5% cash rate by December 2022. In our downside case (33% probability), the cash rate reaches 4.5% by June 2023. There is downside risk to earnings for retailers over the next 18 months. We expect a volatile 12 months and advocate caution.

Wesfarmers strategy day was as comprehensive as usual but did leave us with a few unanswered questions about the finer details of its digital plans, capex outlook and Health ambitions. We expect growth in trade for Bunnings will be difficult without capex and the digital opportunity will take time to build traction. We remain cautious on Bunnings sales outlook.

We would not ordinarily preview a strategy day, but Wesfarmers event on 2 June 2022 will be more interesting than usual given the importance in understanding its digital strategy and its Health segment ambitions. We have outlined the key questions on our mind. While Wesfarmers has very strong existing retail businesses, the future direction and capex required make us cautious about the earnings outlook.

Bunnings accounts for 63% of earnings at Wesfarmers. While a strong business with a leading market position, Bunnings faces challenges in continuing to take market share in our view. The two major areas of share gains are in online and trade. However, in order to succeed in trade and online, Bunnings may need to spend significant capex overhauling its supply chain. At this stage, we do not expect any major shift in supply chain strategy and as a result have modest sales growth and flat margins over the next three years for Bunnings.

Amazon Australia recently released its financial accounts, providing an interesting perspective about the battle online. We calculate that Amazon grew gross transaction value by 48% to $2.6 billion in 2021. Catch Group and Kogan had broadly flat sales. Amazon’s EBITDA margin was 1.9%, which is better than Catch and Kogan. There is an increasing intensity of competition between Amazon, Wesfarmers and Woolworths to capture customers in their “digital ecosystem”. It is not clear who will be the winner. What is clear is that it will take time and money to be successful. The costs will likely outweigh the revenue gains over the next 1-3 years.

Wesfarmers reported a 12% fall in 1H22 EBIT. While the company flagged a drop in group earnings, the fall in Bunnings earnings and higher cost growth raises concerns. We expect earnings to fall in 2H22e as well. The bigger picture is Wesfarmers is lapping very strong earnings across its retail businesses from FY21. We are not concerned about price inflation creating a headwind because Wesfarmers operates in rational markets. However, higher operating costs are likely, including additional investment in digital capabilities as the company competes for a more viable position online.