Woolworths/Endeavour Demerger Benefits?

This story features WOOLWORTHS GROUP LIMITED. For more info SHARE ANALYSIS: WOW

After confirmation of the proposed demerger, investors will be asking: Do I retain my Woolworths shares and/or hold shares in the newly-formed Endeavour Group?

-Scope for both Endeavour Group and Woolworths to re-rate
-Potential return of $1.6bn-$2.0bn to shareholders
-Positive outcomes for demergers since the year 2000

By Mark Woodruff

As first announced in July 2019, Woolworths ((WOW)) has confirmed it will be proceeding with the demerger of Endeavour Group subject to shareholder approval at the General Meeting on June 18. If approved, the demerger will create two independent ASX-listed companies with Endeavour Group likely to be a top ASX50 company.

Post demerger, Endeavour Drinks will own the largest network of retail alcohol stores in Australia with 1,630 stores. The network is spread across the country with an overweight position in Queensland and includes brands such as Dan Murphy’s and BWS. It will also have 332 hotels and 12,364 electronic gaming machines across 1,775 liquor licences. Endeavour operates across two divisions, Retail and Hotels and Macquarie expects a 60/40 split in divisional profitability going forward with Retail being the larger business.

On-premise alcohol consumption in the 2020 calendar year was severely impacted by covid-19 restrictions. While the group saw a sharp reduction in profitability for its Hotels business, this was offset by strong growth in demand for off-premise alcohol, which boosted sales in the Retail business. Overall, earnings were negatively impacted as the Hotels business is a higher margin division than Retail, but Macquarie expects a strong rebound in profitability for Hotels as trading restrictions ease.

Eligible Woolworths’ shareholders will receive one new Endeavour Group share for every Woolworths share held at the demerger record date of June 25. Under the current structure, Woolworths holds an 85.4% share of Endeavour Group with the remaining 14.6% interest held by its long-term joint venture partner, Bruce Mathieson Group (BMG). The new structure will result in both Woolworths and BMG holding a 14.6% stake respectively in Endeavour Group.

After additional shares are allocated to each of BMG and Woolworths, existing shareholders will have a 70.8% direct interest in Endeavour Group.

Now the focus for investors turns to the burning question: Do I want to hold my Woolworths shares and/or hold shares in the newly-formed Endeavour Group?

First, let us turn our attention to the nature of an agreement whereby both companies plan to continue to cooperate into the future to leverage the natural advantages of each business model.

Cooperation Moving Forward

Endeavour Group will be supported by Woolworths via a Partnership Agreement across various categories including supply chain, IT services, marketing services and access to Everyday Reward Services. Endeavour Group will make annual payments of -$564m to Woolworths as part of the agreement of which around $80m is expected to be classified as top-line revenue and $307 million as Other Revenue.

Two thirds of the total payment will be for supply chain and stores, while Woolworths will pay Endeavour around -$13m for offering Pinnacle Drinks brands for distribution in A&NZ and other global markets.

Win/Win Valuation Post Demerger?

Thinking generically, Morgan Stanley has done an analysis of 23 demergers in Australia since the year 2000. This shows both the de-merged entity and the parent entity have outperformed the market, particularly in the first year after de-merger. Median outperformance was 17% for the demerged entity and over 7% for the parent entity.

In further good news for current Woolworths’ shareholders, stockbroker Jarden sees scope for both Endeavour Group and Woolworths to re-rate.

Investors should begin to appreciate Woolworths' ability to generate incremental earnings from alternative revenue streams. These could potentially be either higher returning and/or higher growth.

Meanwhile, the upside for Endeavour Group is expected to materialise if the market begins to see above-market growth, with potential further gains via accelerated capex growth.

However, there are competing views on the benefits of tighter management focus for the newly-formed group. While there should be a greater focus on growth, not having to compete on capital with Woolworths for Hotels, Jarden points out a strong return on 'growth' capex has not been evident in recent years.

Credit Suisse notes that Woolworths has had a 44% historical reinvestment rate compared to the 24% reinvestment rate for the Endeavour Group. In the broker’s view, the group would need to demonstrate a significantly higher return on invested capital (ROIC) than achieved historically to justify a material increase in its reinvestment rate.

Macquarie, on the other hand, sees potential for investment in fleet upgrades for the 12,364 gaming machines. On average, Woolworths replaced 11% of gaming per annum with an average annual spend of -$26m. This lags industry levels of 10%-15% renewals and the broker believes this presents an opportunity for Endeavour Group to invest in its gaming network and rejuvenate its gaming assets outside of Woolworths’s more restrictive ESG settings.

After the demerger, Credit Suisse estimates Endeavour Group will have a leverage ratio of 1.2 times (based on pre AASB16 accounting). The broker views leverage of 1.5 times or below is comfortable for a consistent cash flow generating business.

Dividends

Given most of the group’s debt was historically within the drinks and hotels business, around $1.4bn-$1.5bn of net debt (ex-leases) will now sit with the standalone Endeavour Group business, resulting in a net cash position of $75m for Woolworths.

As a result, the company will be exploring capital management options, possibly returning up to $1.6bn-$2.0bn back to shareholders.

Both entities are expected to maintain the 70-75% payout ratio moving forward, as well as having ample franking credits to pay 100% franked dividends. Dividends will be paid on the second half period (January-June) and are expected to be equal to what the company would have paid if the demerger did not proceed.

Given the dividend payout ratio of 70-75% for Endeavour Group is in-line with Woolworth’s historical payout, it should leave investors with similar near-term income expectations, explains Credit Suisse. The broker retains a Neutral rating and sets a 12 month target price of $38.05. Further broker recommendations follow.

Overall Broker Views of Woolworths

Macquarie reminds us that post-demerger Woolworths remains the largest supermarket across Australia and New Zealand with 1,424 stores, 172,000 employees and $53 billion of revenue. The business is considered highly cash generative and maintains a strong balance sheet.

The business mix now becomes 85% Australian Food, 14% New Zealand Food and 1% BIG W (General Merchandise) on an earnings (EBIT) basis. On a pro forma basis, Woolworths’s operating cashflow (on a pre-covid basis) is approximately $3bn per annum.

Macquarie continues to rate the company as an Outperform given its underlying franchise strength. The 12 month target price is set at $44.50.

Morgan Stanley believes the ex-Endeavour Woolworths business warrants a premium to the market and the Endeavour business. The broker currently has a price target of $44 with an Overweight rating.

Woolworths remains a key pick for Jarden. The broker believes the market is not fully reflecting medium-term upside from the company's investment in the ecosystem, namely in online, data, alternative revenue and new verticals nearer term.

Apart from the demerger and potential capital management, the broker sees further positives that should drive outperformance. These include an unassailable near-term lead in online grocery, which is likely to drive further gains through 2021.

Additionally, Jarden expects a further market appreciation of new verticals and in particular the earnings potential of WooliesX. The broker, not one of the seven stockbrokers monitored daily on the FNArena database, has an Overweight rating and a $43 target. The database has three Buy ratings, one Accumulate and two Neutral (with Citi under research restriction). The consensus target of $42.54 signals 4% upside to the last share price.

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