Wesfarmers’ UK tilt worth watching

Is Wesfarmers’ £340 million ($705 million) acquisition of UK hardware chain Homebase a fantastic opportunity or a case of hubris that will lead to disappointment?

The economics of the deal are very good. Wesfarmers will pay 13.1 times historical operating profit, which, while a little on the high side for the current earnings, does not give away much of the potential upside.

Its total anticipated investment of $1.8 billion ($705 million for the purchase plus $1.03 billion of subsequent investment) represents only 4 per cent of Wesfarmers’ $45 billion market capitalisation. So the purchase is small enough not to cause serious damage, even if it becomes a complete disaster; but it is large enough to make a big impact on earnings if it is successful.

Homebase could catapult Wesfarmers to another level and set it on the path to international expansion. The UK market is substantially larger than Australia, so Homebase could grow to become larger than Bunnings, and there is also the prospect of further expansion into Europe if things go well.

If unsuccessful, Wesfarmers will have egg on its face and a smaller balance sheet.

The downside will be limited as long as Wesfarmers does not allow Homebase to eat cash in pursuit of elusive returns. If things don’t go as planned, it should be able to sell the business at a reasonable price to the next company that believes it can make a go of the UK hardware market.

A number of issues remain, however.

The first is that it will not be possible for Bunnings to achieve its Australian operating margins of more than 11 per cent in the UK market, which is more competitive, more depressed, and different to the Australian market.

Bunnings is a great business that has been honed over many years into a wonderful profit producer for Wesfarmers; but this has taken place in market where it has faced very little competition. Bunnings’ only real competitor was BBC, which it acquired in 2001. 

So is Bunnings a great business because it dominates the market, or does it dominate the market because it is a great business?

The Homebase acquisition will, in time, provide the answer.

There is also the question of whether a successful retail format can travel across an ocean. Nine times out of 10, the answer is that it cannot. Lowe’s, for instance, is one of the most impressive retailers in the US, but its attempt to enter the Australian market through the Masters joint venture with Woolworths has not been successful.

The similarities between the Australian and UK hardware markets are beguiling and the differences are subtle. In the UK, houses are smaller and gardens are smaller. There is also much greater population density, which creates denser geographical catchments, compensating for higher the property costs that UK retailers bear.

Although we think of British people as being the same as we are, they are not, quite. There is a much greater emphasis on home improvement in UK hardware stores, with flatpack furniture an example of this. 

Australians are familiar with flatpack furniture through shopping at IKEA, but hardware stores in the UK were selling flatpack furniture (of pretty average quality) long before IKEA entered the UK, and it remains a major part of their offer. These flatpack ranges run from simple shelving to entire kitchens.

The Masters experience illustrates the limitations of market research and retail expertise when entering a foreign market. Masters had the benefit of a proven hardware retailer, a leading Australian retailer, and large quantities of research. And yet it failed.

If market research were the answer, then retailing would be easy. In all my years in the retail sector in the UK I can’t recall how many times an expert looked at an underperforming retail chain, and gave an incisive review of the problems and a plan to fix them. Once put in charge of the business, they proceeded to mess it up, but in a different way to their predecessors.

Most people can see what’s wrong with underperforming retailers, but very few are capable of delivering success.

Does Wesfarmers have the ability to transfer its domestic success to the UK or will it become the latest in a long line of retailers to discovered that what works at home doesn’t work abroad? It will be a fascinating journey.

Simon Withers led the Consumer Products and Retail team in the Mergers & Acquisitions Department of a London investment bank from 1986 to 1992, and until recently served as mayor of the Town of Cambridge.