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The following 2 ASX share have been on a strong run. It can be tempting to assume those strong returns will continue into the future but our analysts believe they are significantly overvalued.

Wesfarmers (ASX: WES)

Wesfarmers is Australia's largest conglomerate. Its retail operations include the Bunnings hardware chain (number one in market share), discount department stores Kmart and Target (number one and three) and Officeworks in office supplies (number one). These activities account for the vast majority of group earnings before taxes. 

The shares have risen just under 47% in the last year. After the price gains the shares are now trading at more than 32 times earnings which is more than 26% higher than the average price to earnings ratio over the past 5 years. The increase in the share price has also caused the dividend yield to fall below 3% for the first time in a decade. And finally, our analysts also believe the shares are overvalued and they currently trade at a 68% premium to our fair value of $43.

Wesfarmers’ run has occurred in the face of worrisome signs from Australian consumers. It has been a difficult year for Australian retailers in which they navigated soft demand and soaring labor costs. The combination results in a profit margin crunch and declining earnings for many retailers.

While total industry sales are up slightly, volumes are down. It could have been even worse. However, households are adjusting to the cost-of-living crisis by dialing back their savings to next to nothing—the savings rate sits at 1%, down from 4% in fiscal 2023. Without a lower savings rate, we estimate total retailing sales would be in decline.

We believe consumers are comfortable with saving less as long as the housing and equity markets remain strong and excess savings accumulated during the pandemic haven’t been depleted. In the lead up to the global financial crisis of 2007-09, the savings rate averaged close to zero over a decade.

A rising savings rate is the key risk to our outlook for a solid rebound in retailing sales in fiscal 2025. However, this risk to retail sales is skewed to the downside—with little room for the savings rate to move lower. Before the release of the Federal Budget in May 2024, the Reserve Bank had forecast the savings rate to creep up in fiscal 2025.

Conversely, we don’t anticipate the savings rate to meaningfully fluctuate in the near term, and we expect any incremental household income to be spent.

We expect rising wages, a greater number of employed people, and fiscal stimulus to underpin mid-single-digit total retailing sales growth in the medium term—compared with our estimate of only 2% growth in fiscal 2024.

Wesfarmers' diversified portfolio provides exposure to many segments of the Australian economy. Even after the divestment of Coles, most of the conglomerate’s earnings are consumer-related. We forecast group revenue to grow by 4% per year over the next five years, and operating margins to average 10% over the period. We estimate average capital expenditures to equal about 3% of revenue, broadly in line with the conglomerate's past 10-year average.

Bunnings generates close to two-thirds of Wesfarmers' earnings and is the most important driver of the top line in our model. We forecast midcycle revenue growth of 6% per year, ahead of the Australian hardware retailing market at 5%. We forecast Bunnings' EBT margins to average around 13% compared with 12% in fiscal 2023.

Kmart Group is Wesfarmers’ second-largest business, accounting for about 15% of group midcycle earnings before interest and taxes (“EBT”). We expect EBT margins to remain below the cyclical high of fiscal 2023, averaging 6% long term versus 7% in fiscal 2023. However, we forecast the department store sector to continue losing customers to specialty brick-and-mortar stores and online pure-play retailers.

We expect Kmart to outperform Target, because of its clear market positioning as the price leader. For the next decade, we forecast a sales CAGR of 3% for the combined Kmart Group, excluding online pure play Catch.

The industrials segment presents close to over 15% of group midcycle profit. For Wesfarmers’ chemicals, energy, and fertilizers segment, we estimate moderate annual sales declines of about 3% over the next decade, but for EBT margins to remain at 18% from fiscal 2025, following spikes in commodity prices in fiscal years 2022 and 2023.

Reece (ASX: REH)

Reece is an Australian distributor of plumbing supplies and bathroom products, with businesses in Australia, New Zealand, and the United States.

The shares are up over 42% over the past year and are currently trading at roughly 40 times earnings. This is 25% higher than the average price to earnings over the past 5 years. At $26.81 the shares trade at a 98% premium to our fair value of $13.50.

Reece operates two distinctly different business segments: Australia and New Zealand, or ANZ, and United States, or US

Reece ANZ’s customers consist principally of independent, small, and medium plumbing businesses. These businesses are relatively price-inelastic, as costs are passed to the end consumer, and plumbers instead value parts availability and convenience, allowing them to complete their job quickly.

A secondary market is the Do-it-Yourself, or DIY customer. This consumer is generally price-sensitive, and Reece is not the cheapest in the home renovation space. Reece instead adds value with in-store expertise, given the complexity of range and product types. We think Reece is top of mind for DIY consumers, given the breadth of its network.

Reece has over 600 Australian stores, versus the next biggest competitor, Tradelink with around 200 stores. Bunnings has around 350 stores, but these are not plumbing-specific. Reece’s scale allows the ability to source an extensive range of inventory and the flexibility to efficiently allocate inventory between stores. We estimate it stocks more than any other plumbing retailer in Australia. Reece continues to gain market share in ANZ through new stores and growth in product segments including plumbing products for pools, irrigation, and fire protection.

Reece expanded to the US in 2018 via the acquisition of the Morsco plumbing business, followed by smaller bolt-on acquisitions. We estimate it has low-single-digit market share in North America via about 250 stores. Earnings are mostly from commercial and residential construction. Reece intends to increase US exposure to the repair and renovation market.

Although US stores have been profitable, we don't expect returns to be as strong as the Australian business. In the five years before entering the US, return on invested capital (“ROIC”) including goodwill averaged 18% but has since halved. Investment in the US appears set to persist. Management is currently focused on a rebrand and has increased its capital expenditure spending. We think more bolt-on acquisitions are likely as it attempts to gain market share and replicate the ANZ business model, which is predicated on a large store network.

While we believe Reece's Australian operations show signs of a moat in isolation, acquisitions in North America from 2018 have diluted returns on invested capital and we do not award the firm an economic moat in aggregate.

About 75% of Reece ANZ’s earnings are exposed to the residential sector via new house builds, residential repairs, and renovations, or R&R. We expect cyclicality in the residential sector to weigh on revenue over fiscal 2024 and 2025. Thereafter, we forecast demand to return from fiscal 2026, driven by an undersupply of Australia’s existing housing stock, settling at about 200,000 new homes per year by the end of the decade.

In R&R, we expect a pull-back over fiscal 2024 and 2025 as households delay discretionary repairs and renovations in response to the high cost of living. We think Australia’s aging housing is driving demand for R&R over the long term and from fiscal 2026 through to our 2033 forecast horizon, we expect low to mid-single-digit growth. Additionally, we expect Reece will continue to capture market share in the fragmented trade business as it rolls out more stores and increases exposure to new products supporting plumbing for pools, irrigation, and fire protection. We forecast Reece ANZ to gain about 15% market share over the next decade.

Reece’s US operations are principally exposed to commercial and residential construction. The repairs and renovations segment drives about one-fifth of US segment earnings, and residential construction is about 40%, meaning total exposure to residential end-users is over half of segment earnings. We expect the threat of an economic recession, and high interest rates to weigh on near-term earnings due to a slowdown in construction. But we forecast a bounce back in residential construction from fiscal 2026, peaking at 1.5 million new starts, driven by an undersupply of housing and a lower cash rate. Thereafter we model new starts averaging 1.4 million per year over our 10-year forecast period. About 40% of Reece US earnings is from the commercial construction segment, which loosely includes all modes of construction not related to the residential sector. We forecast US commercial construction growth averaging low single digits over our forecast period, driven by economic stimulus and population growth.

We do not expect significant margin growth in either the ANZ or US businesses over our 10-year forecast. ANZ’s earnings before interest depreciation and amortisation (“EBITDA”) margins have been in the midteens for the past decade, and we think this is reasonable for a mature business. The US has high-single-digit EBITDA margins, which are about 300 basis points below much larger competitor, narrow-moat Ferguson. The US industry is fiercely competitive and highly fragmented, with many local, national, and independent plumbing retailers, suppressing margin growth. Additionally, the US doesn’t have the same competitive advantages as it does in ANZ, which aid its high margins, including an established private-label range, a large store network, and centralized distribution centers.

 

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