Sandstone Insights: can Bunnings' growth accelerate?

ASX code: WES

Suggestion: Hold

Need to know

• Bunnings' earnings growth has been modest since fiscal year (FY) 2023 but remains well ahead of US hardware stores like Home Depot and Lowe's
• Store openings have slowed and are expected to remain flat in FY 2025, placing increased reliance on internal growth initiatives like product range refreshes. Bunnings is adding cleaning products and pet food while removing tiles and children's play equipment
• A refreshed Bunnings in-store tool shop launching in the fourth quarter (Q4) of the 2024 calender year (CY) could contribute approximately 1-2% to group sales growth
• The price-earnings ratio (PER) valuation for Wesfarmers (WES) has jumped from 22 times to 30 times over the past 12 months, while the dividend yield is now less than 3%. This suggests premium valuation multiples compared to WES’s own historical levels and peers. Without accelerated earnings growth, WES is increasingly seen as fully priced.

Bunnings' role in Wesfarmers' growth

Where Bunnings goes, so does Wesfarmers, as Bunnings is responsible for approximately 65% of Wesfarmers' earnings and remains the main growth driver for the company..

Post-Covid-19, Bunnings' revenue growth has slowed from high single digits to low single digits, outperforming US peers Home Depot and Lowe’s, which have slipped into negative growth over the past 12 months. Higher mortgage interest rates have impacted consumer hardware sales.

Annual sales growth

In FY 2025, Wesfarmers will slow the rollout of new Bunnings stores in response to higher construction costs. Typically, Bunnings opens three to four large-format warehouses annually. However, in FY 2024, only one new store was added, which is below population growth. This slowdown places more emphasis on Bunnings' internal initiatives to drive sales growth.

Bunnings store rollout: Bunnings has greater store penetration per capita vs Home Depot.

Product range overhaul

Bunnings is aiming to lift inventory turnover through new product ranges. Compared to supermarkets, hardware stores have considerably lower inventory turnover rates. Over the last 12 months, Bunnings has targeted slow-moving product lines, removing kitchen and bathroom tiles and children's play equipment, and adding cleaning products and pet supplies.

The strategy follows a fundamental retail principle: increasing earnings by replacing slow-moving items with higher-turnover products. Higher inventory turnover is expected to generate earnings and returns or at least mitigate cost pressures faced by Bunnings.

While supermarkets typically turn over inventory monthly, hardware stores do so quarterly. Early feedback from Bunnings, supported by our own store analysis, suggests this product mix strategy is working. Going forward, Bunnings is expected to adopt more sophisticated inventory management practices as it upgrades its technology and data systems, gaining better insights into profitability across its various product categories.

Wesfarmers does not disclose the breakdown of sales or earnings within a Bunnings store. We understand there are 12–15 key product categories, with the top six accounting for more than 50% of store sales and being roughly equal in relative size.

Bunnings product categories: 6 largest categories are broadly equal in terms of sales contribution.

(Green = refreshed categories over last 12 months)

Revamped Bunnings in-store Tool Shop

The in-store Bunnings Tool Shop is one of six key product categories inside a Bunnings Warehouse.

The retail experience within the Tool Shop has not substantially changed over the past ten years, despite the shift from corded to cordless power tools and a significant extension of product ranges from manufacturers recently (the electrification of the backyard shed).

Current Bunnings Tool Shop

We argue that Bunnings has been slow to bridge the market gap created by the growth of professional national tool stores such as Sydney Tools (independently owned) and Total Tools, owned by Metcash (ASX: MTS).

Bunnings purchased Adelaide Tools in 2020 (eight stores at the time of acquisition) with plans to expand to 75 stores over the next five years under the Tool Kit Depot brand to target professionals. In our view, the in-store Bunnings Tool Shop has lacked innovation in recent years and is under-utilising the available floor space.

Sydney professional tool shop: utilises more of the vertical airspace to showcase the product range.

Total Tools Professional tool shop: utilises more of the vertical air space to showcase the product range.

Next generation Tool Shop

Bunnings plans to roll out the next generation of Bunnings Tool Shops in Q4 CY 2024, with 50 stores targeted in the near term. We believe that the product line-up and merchandising will move subtly closer to professional tool shops such as Sydney Tools and Total Tools. In our view, high-margin prosumers will be better catered for than the current offering.

We estimate a refreshed tool shop could drive a 20-25% uplift in Tool Shop revenue, or approximately 2% of Bunnings Group revenue once fully rolled out across the network. Given that tool sales are typically a high-margin category for Bunnings, the earnings contribution should be higher.

Expected new features

• Increase in shelf-space: we estimate a 15-20% increase in shelf space, by converting utilised air space within the existing floor space
• Increase in product lines (SKUs)
• Expanded range of powered hand tools

Investment outlook

We consider Wesfarmers as approaching full valuation. The earnings multiple has expanded to approximately 30 times, up from the low 20s of late 2023, and now sits well ahead of the key US peer, Home Depot. The key asset, Bunnings, is relatively mature, and in the absence of increased consumer discretionary and housing-related spending, sales growth is expected to remain in the low single-digit range into 2025.

Kmart and Officeworks remain well-positioned; however, both are relatively mature, offset by their commanding market positions.

At approximately $70.00 per share, investors are paying close to 32 times for Bunnings, factoring in the upside case in lithium, acquisition potential, and relatively steep multiples on Wesfarmers' other businesses just to reach the share price. With the prospect of domestic interest rate cuts within sight, expected in the first quarter (Q1) of CY 2025, it remains unclear what the catalyst will be to challenge Wesfarmers' premium valuation. We retain the Hold rating.

WES vs Home Depot (HD) PER multiple

Risks to investment

Wesfarmers may need to increase capital expenditure and restructure its supply chain to enhance online sales, potentially impacting returns and profit margins. With over 90% of its revenue derived from Australia, the company's growth is closely tied to the local economy. The company is active in acquisitions, particularly in healthcare, rare earth, and lithium, while maintaining a focus on high dividend payouts.

Wesfarmers has a history of acquisition and divestment, with recent examples in healthcare and lithium. There is inherent risk when extending the portfolio, particularly into new business areas, although Wesfarmers has a strong, albeit not perfect, track record in this regard.

Sandstone valuation scenario derives a valuation close to the current share price

• _{The information provided by Sandstone Insights does not constitute investment advice and does not have regard to the specific needs of any person who may receive it. No warranty is given as to the accuracy or completeness of the information and any person acting on it does so entirely at their own risk.}