Why the investment case for woolworths has expired

Woolworths CEO Brad Banducci is breathing a sigh of relief.

He is getting rid of Woolworth’s problem child – its exposure to pokies and alcohol – and the market has reacted predictably to news of the demerger and taken its share price higher.

But before anyone gets too carried away about the news to combine Woolworths Endeavour Drinks with hotels group ALH and then demerge it, it is worth remembering that not a single dollar of value has been created by the announcement. It might in the medium term if the demerger works, but only time will tell on this one. In fact, value will be destroyed in the short term because the transaction costs (which will be paid by Woolworths shareholders) are estimated to be $275 million. Yes, just a cool $275 million!

I am not against the proposal. Woolworths exposure to pokies and hotels has become untenable as more investors and super funds focus on ESG (environmental, social and governance) type issues. For it to remain a top ASX20 company with a diversified institutional and retail shareholder base, it had no choice but to exit the pokies business.

And the demerger might work, as a new company (to be known as The Endeavour Group) is created to own and manage 1,565 retail grog outlets (Dan Murphy’s, BWS etc), 327 hotels with 16,000 poker machines, and specialty businesses including Langton’s Fine Wine and Cellarmasters. With sales just on $10 billion, EBITDA of around $1 billion, it will be an ASX100 company.

Demergers have had a pretty good track record in Australia. Think South32 from BHP, Orora from Amcor, BlueScope from BHP, Dulux from Orica and Treasury Wine Estates from Fosters. More recently, we have seen Coles from Wesfarmers (too early to call) and CYBG from NAB (which appeared to work initially).

But this is not your classic demerger where the “unwanted, capital starved child” is spun out from the main business, and then free from the “interference” of head office, thrives under a refreshed management team. Endeavour Drinks was a “loved child” (formerly run by Brad Banducci), nor was it starved of capital. This is a demerger largely aimed at solving a problem.

Woolworths cited several additional reasons for the separation, describing it as a “win-win” partnership that will allow both groups to focus on their core, be agile and evolve for the future.

The first step is for the combination of the two businesses (Endeavour Drinks and ALH) to form the Endeavour Group in late 2019. This will be subject to Woolworths shareholder approval at its AGM. Woolworths will own 85.4% of the new entity, and the Bruce Mathieson Group (BMG) 14.6%.

The second step will be to demerge the entity, with Woolworths shareholders given scrip in Endeavour Group on a pro-rata basis. Woolworths says it may retain a minority interest in Endeavour (up to 15%), meaning that Woolworths shareholders would own approximately 70% of Endeavour directly. This is expected to be completed in 2020.

What does this mean for Woolworths?

Post the demerger, the new Woolworths will still be Australia and New Zealand’s leading food and everyday needs business, with 984 Woolworths supermarkets in Australia, 180 Countdown supermarkets in New Zealand, 36 Metro branded convenience stores in Australia and 69 franchise stores in NZ. It will also still have its other problem division – the loss making Big W group.

Woolworths says that it has “market leading digital capabilities”, which it is developing in Woolies X and leveraging through its 11.5 million Woolworths Rewards members. These will be extended to the Endeavour Group and with partners such as Caltex and Qantas, may develop into a growing revenue opportunity. But this is still somewhat in the third horizon and the jury is out on how material a business opportunity the leveraging of data might be. In the short term, Woolworths is in the supermarkets business.

And the industry dynamics haven’t changed here. Woolies, Coles and Metcash (IGA) battling it out for market share against discount operators Aldi, Costco, and now Kaufland. Negligible inflation in food prices (sometimes deflation), meaning that sales growth is low single digit. Pressure on margins due to the need to boost service initiatives. Overall, best case outcomes of low single digit earnings growth.

Yet despite this outlook, Woolworths is trading on a multiple of 26.4 times forecast FY19 earnings and 24.7 times forecast FY20 earnings. It offers the prospect of 2.9% dividend yield (for FY19) rising to a forecast 3.1% in FY20.

Woolworths was expensive before the announcement and it is even more so now. The announcement has made Woolworths a sell.

What do the brokers say?

The brokers are also of the view that Woolworths is overpriced. According to FN Arena, of the 8 major brokers, there are 3 neutral ratings and 4 sell ratings (Ord Minnett has no rating). The consensus target price is $29.96 (range $26.84 to $32.90), some 12.7% higher than Friday’s closing price. The following table shows the individual targets and recommendations.

Only 1 broker changed their target price following the announcement (Morgans from $31.24 to $32.75). Most saw it as a positive, with a couple flagging that Woolworths may undertake further capital management initiatives in 2020.

Woolworths: one-year price performance

Source: nabtrade

The bottom line

Woolworths is a “defensive” style stock with a reasonable degree of predictability about earnings and dividends. That’s one of the reasons in the current market environment that it is trading at such lofty multiples. But it is pricey and I think it is in sell territory. It is not going to fall in a hole, but a drift back down to the high twenties is possible.  The demerger in itself is not a reason to hang on.