Aldi's onslaught creates greater headache for Wesfarmers

While Wesfarmers Ltd (ASX: WES) released a robust third quarter trading update to the ASX on 21 April with its all-important food and liquor division up 5.9% over the year to $7.5 billion – and total sales up 5.6% to $13.8 billion over the year, due partly to an extra day's trading in February and an earlier Easter – credit rating agency Moody's has reminded it, and its rivals in the supermarket space of the negative credit risk posed by supermarket chain Aldi.

With Aldi expected to expand its store base by around 16% this year, Moody's expects the German food chain's market share – which jumped from 11.6% to 12.1% in just nine months – to continue growing, hence placing  margin pressure on Coles which is only expected to grow its store base by 3% this year.

In addition to the 'credit negative' impact for mainline supermarkets, Aldi's lower prices have forced Coles and its rivals to enter a price war, which together with fixed costs, like store leases and rising labour costs annually is expected to keep downward pressure on food prices of around 1-1.5% annually over the next few years.

But despite price deflation of 2% over the quarter, Coles sales on a same-store comparable basis were still up a very solid 4.9%.

The only disappointing numbers within Coles third quarter trading update was an 8.9% fall in convenience sales, with falling fuel volumes and prices, and increased competition, outweighing an increase in convenience store sales.

Beyond Coles, the third quarter trading performance of Wesfarmers' DIY operations, Bunnings were equally encouraging with sales up 11% over the year, and 8.3% on a store-on-store basis, while the smaller box format stationary and furniture supplier Officeworks also enjoyed a solid quarter, with sales up 5.6% on the previous corresponding period.

However, the quarter delivered mixed blessings for Wesfarmers' recently restructured department store division, with Kmart reporting a 17.9% increase in sales over the year to $3.9 billion, while the scandal-mired Target chain had the lowest sales increase, up 2.3% for the year and a flat 1.4% on a comparable store basis.

Wesfarmers has already warned that a number of initiatives aimed at reviving the troubled Target business – including plans to shed around quarter of its back office jobs – were likely to affect the fourth quarter results.

The other issue confronting Wesfarmers' is the potential cannibalisation arising from the merger of these two fierce competitors with one division, which could not only cost the company sales and earnings, but see shoppers abandon both stores in favour of rival Big W.

It's still too early to tell what the merger will do to earnings, however early predictions are for Target to run at a loss of $52 million and $100 million in 2017 and 2018, instead of earning about $100 million in each year.

Kmart's earning could be up to $25 million lower next year and $30 million lower in 2018 due to the merger, leading to a cut in forecast earnings for Wesfarmers by 2% this financial year, by 5% in 2017 and just over 6% in 2018.

Meantime, the loss-making coal division – which Wesfarmers' has been under pressure to lance for some time – also delivered mixed blessings with coal production at the Curragh mine 25.5% lower than the previous quarter, due to wet weather events restricting operations at the mine, while coal production at the Bengalla mine was 6% above the prior quarter.

While Wesfarmers' is confronting both the onslaught of Aldi and the continued haemorrhaging of its coal assets, it's also working hard to implement a turnaround strategy for Homebase, UK's second biggest hardware group it recently bought for $704 million.

While Wesfarmers will spend another $1 billion transforming Homebase – which has 265 stores within its retail network – into a Bunnings-like UK retail chain, it also plans to shed around 20% of its 800 staff, including a sacking of the entire board.

While Wesfarmers is a structurally sound business, which is expected go to on delivering strong earnings per share (EPS) growth, the challenges its confronting within each of its core operations makes it difficult to justify buying the stock at a near 50% premium to its intrinsic value.

Greater disclosure is required on plans to successfully combat the onslaught of Aldi's, restructure Target – while preventing any serious cannibalisation that could result from its recent (divisional) merger with Kmart – and successfully reincarnate Homebase as a UK version of Bunnings.

While price targets on Wesfarmers range between $50 and $34.50, the stock looks fully priced against a mid-price target of $41.44.

The likelihood of pending earnings downgrades makes buying Wesfarmers at current levels a riskier short-term proposition.