Exiting UK & Ireland is the least costly option - J.P.Morgan

We already know that on 7th June, Wesfarmers will announce the outcome of their strategic review of Bunnings UK & Ireland. On that day, we expect them to either provide a robust forecast of when and how the business will become profitable or announce their intention to leave the UK and Ireland, with all the unpleasant and far-reaching implications, that until now, no-one even dared contemplate.

Since the Wesfarmers six months results presentation to the Australian Stock Exchange on 21st February and the reported loss in their UK & Ireland division, luck has certainly not been on their side.

Read - Profits collapse as a result of Homebase.

The last thing they would have expected is the 'Beast from the East' and the havoc it wrought across the UK retail industry at the beginning of March. As I'm writing this, I can't quite believe there's more bad weather forecast for this coming weekend, a time when traditionally, the Home Improvement and Garden retailers would see the first peak in sales and the promise of Spring just around the corner.

Bunnings Warehouse Worle - image courtesy of Matt Filer.

Understandably, Wesfarmers has declined to comment on trading at Bunnings UK and Ireland since new CEO Rob Scott announced the strategic review, after slashing the value of the company by more than £580m and unveiling first-half losses of £97m. 

Shaun Cousins analyst at J.P.Morgan believes the poor weather has unfortunately cost Wesfarmers precious time to assess the impact of changes in Homebase and new-format Bunnings stores. It's rumoured that Scott may even decide to push back the decision date for weeks or even months to ensure it has appropriately evaluated the business.

"Rob Scott is expected to be extremely thorough in his review of the UK home improvement industry and the BUKI business, so providing more time to make a decision is more likely than being rushed into a decision. Wesfarmers must re-do some of the initial due diligence – is this a good industry and can the Bunnings offer succeed in this industry and at what scale," Mr Cousins stated in a research document shared with Insight DIY.

In this latest J.PMorgan financial analysis, they have sought to emulate somewhat the work that they assume Wesfarmers will conduct in its own strategic review of BUKI on which it plans to report in June 2018. 

They have concluded that it would be extremely difficult to undo the damage done to Homebase under Wesfarmers ownership (ranges and franchises cannot be reintroduced, the consumer has moved on, the damage to the brand too significant), and hence the profitability that was achieved in the period of ownership by Home Retail Group is very unlikely to occur again.

Their report included a full financial evaluation of the following three scenarios:-

1. Exit the UK entirely.
2. Remain in the UK.
3. Part solution, such as retain the Bunnings stores, but sell-off the Homebase estate.

Their report concluded the cost of Bunnings exiting the UK and Ireland would be less than the cost of persevering and estimated the net present value of exiting would be around £631 million, while the cost of staying would be as much as £863.4 million.

The cost of exiting included £87.8 million in trading losses in calendar 2018, £630 million in lease exit costs (assuming 30% of stores were sub-leased) and £117 million in employee and other costs, offset by about £150 million in proceeds from inventory. J.P.Morgan assumed that about £300 million in inventory would have to be written down by about 50 per cent.

The cost of persisting with Homebase and Bunnings assumed ongoing but diminishing trading losses ranging from £88 million in 2018 to £36.2 million by 2025, store exit costs of around £50 million a year, staff costs around £10 million a year and capex of more than £30 million a year.

J.P.Morgan said Wesfarmers had the option of retaining the 24 new-format Bunnings stores and closing the Homebase stores, but it would struggle to cover overheads and sourcing costs due to the loss of scale and would incur large one-off costs.

Here's a map showing all 24 Bunnings UK locations.

Mr Cousins went on to say "The least-bad outcome is exit."

Analysts now fear that Wesfarmers' foray into the UK & Irish home improvement market could eventually cost more than Woolworths' failed Masters venture in Australia, depending on whether it chooses to exit or tries to turn the business around.

Read - 100 Days to save Homebase.

Source: Steve Collinge & JP Morgan

Check out all of Steve's articles here.

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