Woolworths Takes A Gamble

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Brokers assess the merits of a new entity, Endeavour Group, that will be formed from Woolworths' hotels and liquor businesses.

-Allows Woolworths to focus more on food & groceries
-Enables Woolworths to distance gambling and liquor from its food business
-Progress on leveraging business beyond food & groceries has been slow
 

By Eva Brocklehurst

As conglomerates continue to lose favour, Woolworths ((WOW)) has set about detaching its hotels and liquor business from the core supermarket chain. This eventually will leave discount department store Big W as the company's remaining non-food division.

A new entity called Endeavour Group is expected to be in place by the end of 2019, incorporating ALH hotels (a joint venture with Bruce Mathieson Group) and the Woolworths' liquor arm (Endeavour Drinks). BMG will swap its interest in ALH for a 14.6% stake in Endeavour Group versus its current 29% economic entitlement. Macquarie calculates this implies a slight value transfer to BMG.

The spin-off could mean Woolworths is debt free by FY21, Ord Minnett asserts, with a BBB credit rating for Endeavour Group supporting net debt of $1.4-1.8bn. Moreover, further capital management could be available to re-distribute some of the estimated $2bn in franking credits, post a $1.7bn off-market buyback.

UBS believes the separation, merger and subsequent sale planned for Endeavour Group is likely to mean $2bn in net debt is retained in Endeavour, in turn signalling the company can undertake further capital management in 2020. Endeavour Group, historically, accounted for around 25% of operating earnings (EBITDA) but around 15% of capital expenditure, suggesting relative under-investment.

Assuming the transactions go ahead, Morgans believes this will allow Woolworths to focus on food & groceries, where there is rising competition and higher costs as well as changing consumer preferences. It will also allow Endeavour Group to pursue growth opportunities and accelerate the store renewal program.

Management has admitted that investment has been constrained in this area because of the higher returns on offer in the food business. Morgans suspects the separation will allow Woolworths to exit its gambling exposure entirely in the future.

As a stand-alone entity the broker values Endeavour Group on an enterprise value of $10.5-11.5bn, based on a 14-15x multiple for FY20 forecasts. The valuation range represents a discount to the Australian food business, given lower returns. The broker notes Coles' ((COL)) sale of its Spirit Hotels business was executed at around 15x enterprise value/earnings.

The company expects one-off costs to be less than $275m and any additional or stranded costs to be offset through cost savings or growth. Yet Deutsche Bank does not believe the separation will be that simple, given the interdependence of property, loyalty programs, and the supply chain. A de-merger will add additional costs. Furthermore, cost savings and growth initiatives plan to mitigate costs could have been pursued even without a de-merger, in the broker's view.

Motivation

Macquarie suggests, as Woolworths is currently facing action from the NSW Independent Liquor and Gaming Authority regarding the illegal provision of alcohol to gambling customers, this was a likely consideration in deciding to divest. Woolworths has been under pressure to divest this business because of the adverse social consequences of problem gambling. Deutsche Bank agrees the main benefit in the de-merger will be the isolation of the gambling exposure.

The separation of gambling operations from food will allay some investor concerns, Morgan Stanley acknowledges, although Woolworths will retain up to a 15% minority stake. Earnings in both liquor and hotels declined in the first half of FY19, reflecting the challenges these businesses face, so the broker expects management to focus on generating sales/earnings momentum ahead of the de-merger.

Credit Suisse points out the Woolworths' Dan Murphy's liquor chain is lagging in digital, online and delivery initiatives and there is growing demand for a stronger convenience offering, so management appears to be addressing some of the complexity associated with running the hotels and liquor businesses.

Woolworths' Future

Ord Minnett observes the company has become more open about plans to leverage the broader business beyond food. This is evident in the Marley Spoon ((MMM)) stake and the wholesale and rewards arrangements with the sale of the petrol business. However, progress has been slow and execution risk is higher, while these are long-dated drivers in the broker's view.

Citi has pointed out German competitor, Kaufland, is entering the Australian grocery market and this may be a catalyst for a resumption of price war for private-label groceries. Meanwhile, there is a pending rent review for some of the ALH hotel properties. ALE Property ((LEP)) owns around 26% of the ALH pubs and a review of 79 out of the 86 assets is ongoing.

FNArena's database has four Hold ratings and three Sell. The consensus target is $29.96, signalling -12.0% downside to the last share price. Targets range from $26.84 (Macquarie) to $32.90 (UBS).

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