Wesfarmers Partially Protected Shares (ASX: WESN)

A detailed analysis of WESN was provided in a previous post (click here for the article). I commented how I loved the structure as it provided some downside protection while providing full upside exposure. I also commented it was starting to look 'pricey': that was early February when the price was $39.62 and the price has just kept marching north and is now $42.40. In my prior role as an analyst, it struck me that sometimes we don't want share prices to move too fast; it just means we have to make more decisions as to whether to sell or hold. More decisions = more chances to make balls-ups. Not to mention the tax problems it also creates. However, we do need to keep an eye on reality and decide if we are to hold or sell. 

The table below shows an updated version of the return pay-off of WESN depending on the final share price of WES: 

Some more columns have been added to cater for further assumed dividend increases at a rate of 7% (adjusted for actual ex-dates of dividends). Some other changes have been made to the table such as showing WES price increments of $5. The column on the far right is our rate of return under the various price assumptions. Please note these returns are all pre-tax figures and are gross franking credits. 

The important point to note is that any price movement above the upper protection threshold of $43.11 does not have any downside protection (if that sounded confusing, it is best to go back over the original article). The current price is $42.58. So not only does WESN become less appealing on a valuation perspective as the price increases, the level of built-in insurance also diminishes. This is discomforting from a risk perspective. The case to hold above $43.11 becomes one of fundamentals and not structure. The table below compares WES with its Australian peers (WOW, MTS) and the big overseas supermarkets players (TSCO, WMT):

There are a few other inferences that can be made out of this basic analysis (why is TSCO so cheap!) however WES certainly remains quite expensive. The analysis is a little misleading as WES has other sources of income than Coles and looking at simple metrics such as PE is dangerous, especially when Coles has arguably more for earnings growth from its turnaround strategy. However the key point is risk: higher valuations mean more risk. 

The problem I have is that WES needs to keep growing its earnings quickly to grow into its valuation, yet it is very likely to do exactly that and of course we have the built-in downside protection which is extremely rare for such a good blue-chip company. From an Internal Rate of Return (IRR) perspective, we need both solid gains in dividend growth and the share price to achieve substantial returns. Ideally, we make as few assumptions as possible and so I am going to play at least a little bit of a safe hand and trim back some my shares. For the time being I am holding the majority of the WESN position. 

Kristian