The headline element in the full-year results for Australian big-box home improvement retailer Bunnings is its return on capital (RoC) ratio. For its Australian operations, this hit 41.8%, the highest it has been in eight years.
Masters Home improvement, the failed effort by Woolworths to compete with Bunnings, finally exited the market in December 2016. In 2017 Bunnings' heavy investment in expanding its network is tailing off, and some operational expenses, such as staff hours, have moderated.
For Bunnings as a whole, however, including its UK-based operations, RoC came in at just 30.3%, the lowest it has been since 2014. Those overseas operations lost $89 million, despite considerable investment in refurbishing Homebase, the retail operations Wesfarmers acquired from the UK's Home Retail Group.
The concern among investment analysts is that, in the wake of Masters' exit, Wesfarmers has conjured up an equivalent problem through an uncharacteristically poorly disciplined and hastily executed entry into the UK market. With conglomerate parent Wesfarmers facing the handover to a new CEO in November 2017 - one with banking experience, but no retail experience - there is a question if the loss-making BUKI operations can be restored over the year to come.
Meanwhile, Wesfarmers has produced what it describes as a "record level of earnings" for its FY2016/17. In results released on 17 August 2017, the company reported sales were $68,444 million, up by 3.7% on the previous corresponding period (pcp), which was FY2015/16.
Earnings before interest and taxation (EBIT) were $4402 million, up by 27.2% on the pcp. Net profit after taxes for the year was $2,873 million. This represents as increase of 27.6% on the pcp, if write-offs of $1844 million are excluded from the pcp results. (The FY2015/16 write-offs related to a revaluation of the company's Target retail operations and other assets.)
In comments reported in the Wesfarmers results news release, Mr Goyder stated:
The results achieved during the year demonstrated the strength of the Group's conglomerate structure, as well as our focus on cash generation and capital efficiency. A strong recovery in the performance of the Industrials division reflected higher earnings across all three business units, and was driven in particular by higher coal prices and increased coal production in the Resources business. Retail earnings were also above the prior year, supported by continued strong momentum in Bunnings Australia and New Zealand (BANZ), Kmart and Officeworks.
Coles overall saw revenue fall by 0.1%, with EBIT declining by 13.5% on the pcp. Its food and liquor business had returned a lift in revenue of 1.6%, but the convenience area recorded a loss in revenue of 8.2% compared to the pcp.
Kmart saw revenue lift by 7.5% on the pcp, with EBIT gaining by 17.7%. Target's sales fell by 14.6% on the pcp, while EBIT remained negative overall, but was positive by $3 million, with the omission of significant items. Meanwhile, Officeworks saw revenue lift by 6.1% on the pcp, with EBIT climbing by 7.5%.
In Resources, revenue increased from $1008 million in the pcp to $1746 million in the reported year, a lift of 73.2%. EBIT was $405 million, up from a loss of $310 million in the pcp.
Bunnings now operates in two divisions, Bunnings Australia and New Zealand (BANZ), and Bunnings United Kingdom and Ireland (BUKI). Michael Schneider is the overall CEO of the combined Bunnings, and also managing director of BANZ. Peter (PJ) Davis is the managing director of BUKI.
BANZ revenue came in at $11,514 million, up by 8.9% on the pcp, while EBIT was $1334 million, up 10% over the pcp. Total store sales growth was 8.9%, while store-on-store (comp) sales were 7.3%. BANZ delivered a return on capital (RoC) of 41.8%, up from 36.6% in the pcp.
The company noted that results for the fourth quarter of 2016/17 were particularly strong, with total sales up by 11.4%, total store sales up 11.7% and store-on-store sales up by 10.4%, as compared to the fourth quarter of 2015/16. During the reporting year, Bunnings opened 18 new trading locations in total, consisting of nine warehouses, eight small stores, and one trade centre.
BUKI reported revenue of $2072 million (GBP1229 million). This generated a loss of $89 million (GBP54 million). The company reports that for the fourth quarter of 2016/17 total sales decreased by 6.8%, with store-on-store (comp) sales down by 4.3%, as compared to fourth quarter 2015/16. However, transaction numbers for the quarter were up by 3.2%.
BUKI opened four Bunnings Warehouse stores during the reporting period, three in East England and one in South England. The company also closed nine Homebase stores, reducing the network size to 251.
Total revenue for Bunnings was $13,586 million, up by 17.4% on the pcp. EBIT was $1245 million, up by 2.6% on the pcp. The overall home improvement operations delivered a RoC of 30.3%, down from 33.7% in the pcp.
In his overall remarks on the company's performance, Mr Goyder stated:
Bunnings in Australia and New Zealand recorded strong earnings growth of 10% after expensing a number of matters relating to the store network. Homebase's trading performance in the UK and Ireland was affected by the pace of repositioning the business. Pleasingly, the four Bunnings pilot stores opened during the year have been trading well as has the fifth, just recently opened.
We continue to be excited about the opportunity in the UK and Ireland, albeit trading in the Homebase stores is weaker than we would like. We are strengthening the team and working hard to make this a good investment over time.
In his comments on BANZ, Mr Schneider began by highlighting the retailer's progress in light trade sales:
Sales growth was strong in both our consumer and commercial segments, with very strong performance among our light commercial segments, reflecting the good work that's gone into product innovation and offerings relevant to the various trade segments we serve as well as improved pricing in digital engagement.
The subject of trade sales came up later in his remarks as well:
Our engagement of light trades as well as deeper relationships with larger builders ensures we're well-positioned to meet the needs of this sector of the market.
Mr Schneider also highlighted some of the extensive work that has been undertaken to significantly upgrade the existing store network:
The images on the bottom of this slide show the demolition work underway at Caringbah and an illustration of our new warehouse, which gives a sense of the scale of these sort of projects. As we continue to develop our network, it's likely that similar scale developments will become a feature of our network planning.
In the formal accounting documents accompanying Wesfarmers 4e report, it was mentioned that one negative offset to the good earnings growth was:
...higher store closure provisions within BANZ's trading results, arising from the agreement with Home Consortium for new sites, together with additional writedowns in the second half related to future network changes and in-store display assets.
Further investment in store upgrades and category refresh works was supported by a disciplined capital expenditure program.
In his remarks, Mr Schneider also said:
Of note is our expectation that we'll be able to finalise our lease arrangements with the Home Consortium later this year, which will enable us to develop the remaining Masters sites that we've indicated we'll move into during the second half. This will also see an increase in capital expenditure this year.
The formal documents stated:
Access to the majority of the former Masters sites remains dependent on the outcome of the valuation process between the two joint venture partners. In the meantime, agreements have been reached with landlords of two stores and conversions are well progressed.
Taken together, these remarks may indicate two things. The first is that Bunnings' expansion plans for the near future may be more concentrated on improving its existing store network, rather than in further geographic expansion. It is possible that, having had the opportunity to examine the higher amenity warehouse stores that Masters built, it may incorporate many of those features into its own future builds. That benefits consumer, of course, but it also benefits Bunnings staff. (Some of the older warehouses are not pleasant places to work in at the dead of winter or the height of summer.)
Secondly, there may also be a hint here that Bunnings is increasing its efforts in the trade area to some extent. With some of the turmoil generated by the acquisition of the Home Timber and Hardware Group by Metcash, and some significant independent hardware store closures over the past six months, Bunnings may see room for expansion.
Of course, it is also necessary to issue the usual Bunnings warnings: objects that appear in the mirror of the results announcement may be obscuring other strategies directly behind them. For example, Mr Schneider made no mention of a pending deal with GWA Group.
This was mentioned in that company's results announcement by its CEO, Tim Salt:
Finally, an area where we haven't been as focused and we're starting to wake up to the opportunity, is in assisted living, which some people call age care, but that's an area that Bunnings are certainly themselves looking to drive harder and we're partnering with them very strongly now to create growth opportunities both for us and for them in that space.
It is hardly surprising that BUKI attracted a good deal of attention from analysts. Mr Schneider laid out a staunch defence of its operations and future prospects. He began by outlining those areas where BUKI had suffered setbacks:
Trading during the year was impacted by price deflation following the introduction of Every Day Low Pricing across the Homebase business as well as lower volumes of high-value kitchen and bathroom sales as those categories were significantly repositioned away from an installation and in-home services model.
He went on to outline what BUKI was doing to mitigate these problems:
Our new range of kitchens is now in all pilot stores. A refresh and relaunch of this offer across the Homebase network is now underway. Whilst we are pleased with the new offer, we are conscious it will take some time to get traction with customers as they have become very used to a promotion-driven installation model across the market.
Expansion plans, according to Mr Schneider, include up to 20 Bunnings stores in the UK by the end of calendar 2017.
Our aim is to end this calendar year with between 15 and 20 Bunnings stores open or near completion. These will give us some important benchmarks to trading patterns and customer participation across the northern winter. As we've always said, further investment is predicated on successful pilots. Proof of concept is a very big area of focus for the business in the year ahead.
He concluded by admitting to the difficulties BUKI faces, but reiterated that this is a long-term project.
I expect trading to remain challenging for Homebase at least in the short-term as customers continue to adjust to the new offer. In addition, until we reach sufficient scale with the roll out of the Bunnings format, business performance will continue to be negatively affected by disproportionate non-operating costs and disruptions associated with the new store openings. As I said before, this is a significant long-term transformation project and PJ [Davis], the team and I are committed to driving the agenda hard in the year ahead.
Respected analyst David Errington of Merrill Lynch picked up on some of these points in his questions:
On BUKI, one of the most concerning things I've heard on this call was Mike saying that you're trying to convert UK customers to a non-promotional offer.
Now you've lost a lot of money in this business this year. You lost - the biggest trading period, you've lost nearly $30 million, and that's your best trading period. And you're going to try to convert a market. Now most of us who have covered whether it be wine companies or the UK retail is the whole UK market is a promotional market, that's what the UK customers are based - that's what they deal on, whether it's BOGOFs [buy one get one free] or whatever it might be.
You're going to try to convert the market to being non-promotional. That, to me, is a real worry, and I'd like to hear why you think that strategy is going to be successful going forward.
Mr Schneider responded to this criticism by saying in part:
We're seeing from the first five pilot stores that have been opened that when you're really clear on what EDLP is and you really strive to create breathtaking value for customers, they trust it and they shop with the store. So we're seeing that in the transaction sales [going] up ... in the pilot stores.
He went on to agree that EDLP was "no silver bullet", but said this was only part of the developments at BUKI:
The other thing that we've got is a whole lot of work happening now around different types of marketing collateral, both traditional and digital, to engage customers in the Homebase business. It's going to be a long slog, but certainly from what we're seeing in the way we've established the Bunnings pilots that they're performing well on an EDLP basis.
Mr Errington responded with an acute point:
But what's the worry, Mike, [is] that the Homebase stores, which is the bulk of the priority - the 260 Homebase stores that you're converting to being non-promotional. What's the risk that they turn into a real disaster?
Mr Schneider agreed that there was a risk, but sees it as being offset:
Well, I guess there is a risk. I think the challenge that the team have got in front of them and the work that we're doing is all about positioning the stores as a core home improvement and garden offer, and that's one of the big things that's sort of underestimated, I guess, in seeing the transition... It will take time for customers, irrespective of the pricing framework, to actually understand what those stores are there for, because that market's grown up with that business being something different.
For what was a relatively tough year through at least three of its quarters, the results from BANZ are quite good. Not only did weather play a role in decreasing sales, but there was also, nearly a year ago, a high level of discount sales activity coming from the closing Masters stores.
If there remains an open question around Bunnings' future, it involves the company's commitment to digital, online engagement. While there has been something of a dismissal in the past of the potential effect the entry of Amazon could have on the home improvement industry in Australia, it is worth noting that analysts this year have been sounding a note of caution about home improvement retailers The Home Depot and Lowe's Companies as regards competition coming from the biggest online retailer in the world.
This has been partly fuelled by Amazon's move into selling larger home appliances sourced from Sears, but the greater point is that much of what Amazon currently stocks can suck sales away from home improvement: flashlights, lighting, batteries, light globes and so forth. Certainly, Amazon is better established in the US, but The Home Depot is headed for 2017 sales of USD100 billion and EBIT close to USD15.5 billion, yet is regarded as vulnerable.
However, what has really drawn most analysts' attention is the activity at BUKI, whose success or failure could have consequences for what BANZ does here in Australia. To understand why analysts are so concerned, and why the investment in BUKI - only 8% of total Wesfarmers capital, according to incoming CEO Rob Scott - is seen as so critical, it's a good idea to look at how the different Wesfarmers interact, and how this plays into Wesfarmers' competition with its main rival, Woolworths.
Understanding the interplay between the different activities at Wesfarmers is of particular importance at the moment, as Mr Goyder is set to be replaced by the person who has managed Wesfarmers' industrials segment, Mr Scott, at the company's annual general meeting in November 2017.
Speaking to a gathering at the Melbourne Business School in May 2017, Mr Goyder said:
I don't worry too much about legacy. I'll walk to the next challenge. Rob [Scott] will change things, and he should change things.
Mr Goyder went into particular detail about the importance of the Wesfarmers board:
I was lucky. I always had a board that was patient. When I started at Wesfarmers, the board were all farmers, and now I think I'm the only farmer. There's a culture of being patient.
This comment is notable, as some analysts have suggested Mr Scott could be overly influenced by the current chairman of the Wesfarmers' board, Michael Chaney. Mr Chaney was managing director of Wesfarmers immediately prior to Mr Goyder, and he was the primary instigator of setting up Bunnings, modelled on the US home improvement big box operator Home Depot.
There are two areas at Wesfarmers Mr Scott will need to consider seriously. The first is exactly how a conglomerate such as Wesfarmers can function most profitably in the modern era. To what extent does each business division remain in its own operational silo, and to what extent are resources shared?
The second is how the company manages its ongoing competition with Woolworths. At the moment the two companies are locked together in a duopolistic struggle over several retail markets - groceries, liquor and discount fashion - while, external to this struggle, the overall retail market continues to fragment, due to the entry of overseas competitors, and increased online competition.
These two areas interact in interesting ways. In fact, if you wanted a tagline for this year's annual results from Wesfarmers it might well be "Grant O'Brien got one thing right". That one thing that Mr O'Brien - former Woolworths CEO and author of its disastrous rollout of Masters Home Improvement - got right was that Bunnings posed a direct threat to Woolworths' grocery business.
This year, sales for Woolworths supermarkets in Australia rose by 4.5%, while EBIT fell by 2.4%. Coles, as mentioned above, saw EBIT decline by 13.5%. However, this represents less of a "winning" or "losing" situation, and is more an indication of how aggressive each retailer has become. As the managing director of Coles, John Durkam, put it in his remarks to analysts:
We saw significant investment from our competitors, combined with a subdued consumer market. In response to these conditions, we took the deliberate decision to use FY 2017 to invest in the long-term sustainable growth of the Coles business.
Wesfarmers can accept that kind of decline in Coles earnings as an investment in lower prices and gains in market share, because it has higher overall earnings, and more diversified depth, than Woolworths. Bunnings is an important contributor to that.
It is also worth remembering just exactly how badly Masters and the mismanagement of its grocery business has affected Woolworths. Woolworths' market cap in 2007 was about $33.3 billion, while Wesfarmers at that time was at $17.7 billion. Allowing for inflation, that would translate into over $40 billion for Woolworths in today's dollars, and $22 billion for Wesfarmers. Today, Woolworths is still at around $33 billion, and Wesfarmers is around $48 billion.
It's not really possible to make a straight comparison on a market cap basis over time (due to acquisitions and divestments, in part), but this does give something of a picture of what Woolworths has lost.
This does not mean, however, that Wesfarmers has "won", or even that it is currently winning. Woolworths remains a strong competitor. The current CEO of Woolworths, Brad Banducci, appointed 18 months ago to the role, has managed to move its grocery business in a positive direction. In discount fashion, Woolworths' Big W retailer remains a disaster, and last year, through a major writedown, Wesfarmers acknowledged its failure with Target. Both operations could not be sold in the current market, and neither company can shut down its fashion retailer, as this would instantly hand an advantage to their competitor.
The key strategy for Wesfarmers is to continue to fight what has become a war of attrition, between two competitors which are good at customer retention, but less good at increasing market share. Woolworths, in contrast, simply must innovate, potentially through increasing vertical integration in fresh food. That comes at the cost, though, of a higher risk profile.
In this context, for some analysts Wesfarmers' investment in BUKI is similar to seeing a long-distance runner sign up for a 400 metre sprint right before the main race. It's a distraction, requires capital, and has an uncertain outcome.
Wesfarmers' own point of view is quite different. Far from being a possibly destabilising development, the BUKI expansion is seen as potentially providing a form of longer-term stability.
The expansion of the Bunnings store network in Australia in response to the launch of Masters was definitely an excellent strategic move, but it did open the company up to further risk in the event of a downturn.
That is because, once a store network has expanded, there is no simple way to diminish that exposure. While the housing market currently continues to perform well, there is little doubt that at sometime in the next decade the market will contract, ceasing to grow at its current accelerated rate. By expanding overseas to the UK and Ireland, Bunnings is gaining entry to an economy that is associated with the Australian economy in only a minor way. In the event of a downturn, it could provide a much-needed continuation of growth.
It is also a matter of timing: if Wesfarmers is to expand overseas, then late 2016 was a once-in-a-decade (at best) event. With Bunnings coming directly off a five-year campaign to reduce the impact of Masters, it was over-staffed with highly competent executives at the peak of their game, and teams existed which were used to working on aggressive expansionary tactics.
That said, there is little doubt that Bunnings did underestimate the depth of the task BUKI represented. One part of that was that Homebase turned out to be, operationally for Bunnings, in worse shape than thought. The more important aspect, though, was that Bunnings did not understand how difficult making the necessary adjustments to a different culture, and a different market position, would be.
The place where the need for this kind of adjustment has become clear was revealed by Mr Davis during a site visit by investment analysts to Bunnings UK in mid-March 2017. In a tense question and answer sessions with Mr Errington, Mr Davis admitted that sales in the kitchens and bathrooms had not performed as expected. In part Mr Davis said:
To be fair we didn't expect to lose the volumes in kitchen and bathrooms that we did. All right. So some of the strategic moves and the repositioning of the business have had impacts that we didn't project into the future. But we are reestablishing that right now.
Well kitchen and bath [originally] consisted of] five brands. Some of it is produced in Germany, some of it is produced by one of our key competitors in this market. Three of the brands have not come across from HRG [Home Retail Group, former UK owner of Homebase].
So we are going through a major transition in relation to kitchen and bath. Key principles are that we do not want to support one of our major competitors, in manufacturing, key principles are that we want a simple execution. We have closed installation down because we don't believe that it is key. We believe that, people will tell you can't sell kitchen and bathrooms unless you install them. We'll go talk to some other big players in the world that don't install kitchen and bath, including ourselves in Australia.
Mr Errington then asked:
But what about in the UK. Do they expect you to install in the UK?
Mr Davis replied:
But we had already had a large proportion of our business in this market that is not installed. What we want to do is to grow the non-installed part so that... Some of the issues we had were in remedials. So after a kitchen or bathroom is installed in someone's house, prior to us owning the business, we would've had to go back and repair it, and there are a lot of costs associated and a large team that were going back and fixing kitchens and bathrooms.
It would seem that BUKI's solution to the kitchen problem has been to get its Australian supplier, Kaboodle, to design kitchens it thinks are suitable for the DIY UK and Irish markets, with a slight rebranding to "Kit+Kaboodle". Marketing for these kitchens has been launched in a brochure and on the Homebase website.
As far as HNN can tell by looking at the illustrations, these seem as serviceable as any Kaboodle kitchen. The brochure goes to great lengths to assert the quality of the products, including a 10-year warranty, and a "lifetime advantage" extension of the warranty for customers who install kitchens in their principal place of residence.
The parts of the brochure that deal with the mechanics of kitchen selection and installation are well done as well, following the pattern of Kaboodle's Australian marketing.
However, much of the actual front-of-book display marketing is much less successful. This begins with a rather odd naming system. Two styles of kitchen are offered, classic and contemporary. The names for the classic styles are: steamer, roaster, griddle, poacher and baker. The names for the contemporary styles are glaze, simmer and miller.
The copy used to describe these kitchens seems less than entirely professional. This begins with the airy paragraph:
So, we found a way that families can save and still enjoy designer styling with high-end kitchen features. Imagine a kitchen designed by you, that comes in a box and is easily put together. The results? Take a look through our brochure and see for yourself!
Not great, but not awful. The actual descriptions of the kitchens are less successful.
For the "steamer" kitchen:
Steam up a new kitchen in your space with my solid timber doors! Our Shaker style doors come in natural oak and two painted finishes - just in case you want to tone me down. My classic style is adaptable to suit both traditional and modern style kitchens.
For the "griddle" kitchen:
Try using my light blue country styled doors in your kitchen for a modern take on traditional. My retro farmhouse look is sure to steal glances and will bring your space to life. You'll be able to cook up a storm in no time!
For the "poacher" kitchen:
I am country, classy and everything in between! My poached cream doors with stylish grooves are an everlasting look that won't date your space. I work wonders with a timber worktop and plenty of natural light.
("Poached cream", as far as HNN can tell, is a form of Polish moulded custard.)
Leaving aside the pronoun confusion in the first example, this copy seems to be emulating the text of a first-year reading primer. The marketing merit of conversationally inclined kitchen cabinets is somewhat questionable. It is not an approach that shows an effective track record elsewhere.
The contrast with kitchens offered by B&Q is quite strong. Cooke & Lewis Carisbrooke, Santini, Stonefield, Sandford, Chilton, and Cooke & Lewis Appleby are names of kitchens offered by B&Q. The description of the Chilton White Country Style kitchen reads:
Our Chilton White Country Style kitchen is tastefully traditional with modern updates for that easy, laid-back atmosphere. White units on white walls are a trend-led feature, anchored by a darker statement worktop, completing the look.
That is professional copy. Equally, the kitchen images from Kaboodle are adequate, but the images used by B&Q to promote its kitchens, to an existing, well-established market, are more professional, showing people in the kitchens, and adding key background elements.
As HNN has mentioned above, Kaboodle is generally a competent company when it comes to marketing, making a little go a long way. What seems to be happening in this case is that the company is being called on to manage a very difficult task - essentially the introduction of a new category of kitchen to a part of the market unfamiliar with the product - with only a very limited budget, limited means, and an imperfect understanding of the market it is approaching.
The point of this is not at all to criticise Kaboodle. It's that this minor misstep in marketing points to larger possible problems at BUKI. To really get to the roots of what that problem may be, it is helpful to go down a theoretical path.
A helpful source is one of the more popular market development books of recent times. Jobs to be Done: Theory to practice by Anthony Ulwick has been a very influential work, especially on Clayton Christensen, author of The Innovator's Dilemma, which gave us the modern business theory of "disruptive innovation".
To read the rest of this article, please download edition 3-10 of Hi News:
HI News Vol.3 No.10: Bunnings-Wesfarmers results 2016-17