Wesfarmers trading update provides a reminder about the challenges facing the retail-centric company. Kmart’s earnings fell 56% in 1H22e on a sales decline of 10%. The fall in earnings suggests higher costs, some of which will persist as global supply chains become more expensive and online grows as a share of sales. While Kmart had a tough half, Bunnings earnings may have only fallen slightly and WesCEF was up.

Wesfarmers has increased its bid for API to $1.55 per share, a 12% lift in its offer price. The API Board has indicated support. While the enterprise value is less than $1 billion, it is an important development for Wesfarmers as it establishes a Health segment. More acquisitions may follow. API is also likely to be part of Wesfarmers digital ecosystem over time.

Wesfarmers reported FY21 EBIT up 18%. However, Bunnings and Kmart earnings are likely to fall in FY22e given lockdowns and a normalisation in demand. These two businesses account for over 80% of group earnings. The company also flagged investment in its “digital ecosystem”. We expect elevated capex to persist as Wesfarmers catches up in online. There is upside risk to capex projects as IT and supply chains may need to change if online penetration becomes meaningful.

We initiate coverage on Wesfarmers. While Wesfarmers retail businesses are well positioned, they have seen significant benefits to sales and earnings over past two years, which will partly reverse. As a result, retail earnings could drop over the next two years. A special dividend is possible near-term. Wesfarmers has over $10 billion in acquisition capacity on our estimates, but in recent times has only made smaller adjacent acquisitions within existing businesses. The creation of a Health segment is one logical extension for the company with an Australian healthcare industry EBITDA profit pool of over $28 billion.