David Errington, an investment advisor with Bank of America Merrill Lynch, told clients in mid-2016 that Bunnings’ investment in Homebase should be written down to zero.
Errington argued the Brexit decision added to the challenges facing Bunnings in reinvigorating the Homebase chain, the second largest hardware retailer in the UK, but a declining force under its previous owners, Home Retail Group.
Errington predicted it would be many years before the business would reach sustainable profitability, despite an initial $1 billion cash injection to restructure and rebrand Homebase following the acquisition.
He told clients the injection of capital would “add little to the opportunity of Homebase to return to profits” and would see Wesfarmers shareholders lumbered with a capital loss of up to $4 billion on the UK venture.
From the initial announcement by Wesfarmers of the Homebase acquisition, Errington has been a strident critic of the acquisition of the 250 store chain which has an estimated 12.5 per cent market share of the UK home improvement market.
The biggest player in the UK market, which is valued at around $66 billion, is Kingfisher, with a 39 per cent share while Travis Perkins is estimated to have a 10.5 per cent slice of the national market.
The negative sentiment of Errington and several other analysts was perhaps coloured as much by the failure of Woolworths’ Masters Home Improvement chain in Australia as well as the underwhelming metrics of the rundown Homebase chain.
Wesfarmers announced it would acquire Homebase in January 2016, less than six months after Woolworths conceded the Masters Home Improvement chain it launched in a joint venture with Lowes, the American home centre retailer, was a failure.
While Bunnings’ Australasian business was an obvious beneficiary of the demise of Masters Home Improvement, which had closed all stores by December 2016, analysts are also expecting the hardware giant’s extraordinary sales and earnings growth to taper off.
The pessimism is based on a view that Bunnings Warehouse (and a number of other major retailers, including JB Hi-Fi and Harvey Norman) are over-shopped and at risk of reduced earnings.
Citigroup, Morgan Stanley, Commonwealth Bank and UBS are among the firms that are concerned about the ratio of retail floorspace of major retailers to population catchments and the cannibalising impact of having too many stores.
A defence plan
In the short term, Bunnings Warehouse has shown few signs of over-reaching and, in fact, believes its store network strategy is a key defence against online retail competitors.
However, Wesfarmers and Bunnings Warehouse management are just as mindful as the analysts about the limits on further store development in Australia and New Zealand.
That is precisely why Wesfarmers decided to buy Homebase in January 2016, at what was an objectively fair price that reflected the fact that the UK chain was, what they call in real estate circles, a renovator’s delight.
Woolworths chose the wrong joint venture partner and tried to create a new chain from scratch, using a hybrid business model that included wholesale and marketing services to an independent competitor to its new stores.
Woolworths management team was thin and largely inexperienced in the category, relying heavily on advice from its US partner on store design and ranging.
The store rollout strategy was flawed and didn’t allow the fledgling chain to achieve efficient and effective marketing to support the new stores.
The A team
Analysts might be spooked by the new geography itself and even the continuing challenging retail conditions in the UK, Brexit included, but Wesfarmers has taken a much more logical approach in its expansion plan than Woolworths did in Australia.
For starters, while Homebase was struggling and closing stores as sales and earnings declined, it is still the second largest player in the home improvement market and a known quantity compared to a greenfields venture.
Homebase had an established supply chain, which Bunnings Warehouse was well placed to enhance, adding new products while acknowledging the favourite brands of the existing customer base.
Homebase had staff and existing sites and an immediate opportunity to increase the density of stock and to improve floorspace productivity.
Homebase is one of the lowest sales per square metre levels of any retailer in the UK, which Bunnings argues is a pointer to the potential for improving sales within its existing footprint and before any new store development.
However, most importantly, Bunnings Warehouse has a strong management team and an experienced backup team of consultant advisors.
Bunnings Warehouse dispensed with the leadership team at Homebase when it formally took control of the business, a move designed to tackle cultural change and to implement a turnaround and transformation strategy that will in due course convert all stores to the Australian brand.
The management team is led by managing director, Peter Davis, a hard-nosed hardware retailer who was schooled by Joe Boros at Bunnings in Western Australia.
Davis’ experience includes the acquisition of the venerable but unprofitable McEwans chain in Victoria that became the platform for the first Bunnings Warehouse stores.
Davis was also a key player when Bunnings acquired the under-performing BBC Hardware and the Hardware House stores, which were converted to Bunnings Warehouse stores.
In other words, Davis not only knows the Bunnings Warehouse culture and business model down to smallest detail, but has also been in a leadership role in acquisitions, restructures, store developments and conversions of acquired businesses.
Wesfarmers’ leadership investment in the Homebase venture runs much deeper than Davis, however, with an advisory board that includes Archie Norman, John Gillam, Matt Tyson and Michael Mire.
Gillam, who recently stepped down as MD of Bunnings Australasian business, was at the table when Wesfarmers decided to venture into the UK market and, potentially the European market, with the Homebase acquisition.
Archie Norman is something of a legend in UK retailing, having turned around the ailing ASDA grocery chain, but has strong connections to Wesfarmers after advising on the turnaround strategy and assisting with the recruitment of key management for Coles food and liquor business.
Norman has brought former McKinsey & Co partner and fellow Lazard advisory firm director, Michael Mire, onto the Bunnings UK advisory board.
The board also includes Tyson, formerly an executive with the market leading Kingfisher hardware group and the MD Woolworths recruited in a vain bid to save the Masters Home Improvement chain.
The financial oversight of the venture is overseen by a Bunnings Group Council, as well as Wesfarmers and Bunnings management in Australia.
Last month, Bunnings appointed David Haydon as trading and commercial manager for Homebase to further bolster the venture’s management team. Haydon is returning to the UK after working in the Officeworks leadership team and brings to Homebase experience with B&Q, Wickes and Superdrug.
Prior to joining Officeworks four years ago, Haydon was commercial and marketing director for Kingfisher Plc’s international businesses, overseeing commercial and marketing strategies for high-growth markets including China, Poland, Russia, and Turkey.
Bunnings United Kingdom and Ireland, which controls the Homebase stores, posted sales for the third quarter of $400 million with customer participation, as measured by transactions, increasing by 2.2 per cent on a like for like basis.
For the financial year to date, total sales for the UK venture are $1.429 million with customer participation over nine months increasing by 6.9 per cent.
Peter Davis said trading during the quarter was negatively affected by the continued repositioning of the kitchen and bathroom offer, “while the performance across other core home improvement and garden products was pleasing”.
Davis said the first Bunnings Warehouse pilot stores have been well received by customers, team members, and the community,” Davis said.
At least 10 further stores are due to be converted to the Bunnings Warehouse format by the end of the year.
Wesfarmers has indicated that it factored in various risks, including Brexit and currency movements, when it was assessing the Homebase acquisition and remains confident about the prospects of the hardware venture.
Analysts, including Errington, believe Brexit could see the UK economy slide into a recession and hit hardware sales, but Wesfarmers believes it could offset any general downturn by improving sales in Homebase stores, especially in refurbished and rebranded outlets.
Wesfarmers also remains confident of long-term value creation associated with the UK business and a positive return on investment for both the acquisition cost and capital expenditure for restructuring the business and upgrading stores.
Wesfarmers is also confident improved efficiencies in the business will boost profit margins which average around six per cent in the UK, compared to around 10 per cent for the Bunnings Warehouse chain in Australia.
In the third quarter of the current financial year, Bunnings Australia and New Zealand achieved total sales growth of 7.7 per cent to $2.8 billion, while year to date sales are running at $8.75b, up 8.1 per cent on the same nine month period last year.
A further 17 sites were under construction at the end of March 2017, adding to the floorspace that is troubling some investment analysts.