Woolworths shareholders have an uneasy sense of déjà vu.
Three years after arguably the worst deal of the decade – the $94 million sale of Woolworths’ Dick Smith consumer electronics chain to private equity investors –Woolworths is once again contemplating selling assets it has been unable to fix or believes would be better off in other hands.
And once again private equity appears to be in the mix.
Outgoing Woolworths chief executive Grant O’Brien has confirmed what fund managers have suspected for several months: everything is on the table as Australia’s largest retailer attempts to regain its blue-chip status after an extraordinary 12 months of turmoil which shows no signs of coming to an end.
The board, led by new chairman, Gordon Cairns, is reviewing all Woolworths businesses, including their valuations, strategy and future prospects.
Depending on the outcome of these reviews, the Woolworths group could emerge intact or be broken up into its major parts – food and liquor, hotels, petrol, general merchandise and home improvement.
Those of us getting long in the tooth will remember that Woolworths once owned a specialty clothing business, Rockmans, a grocery wholesaling operation, AIW, and a meat processing and printing business, Chisholm Manufacturing.
It sold Rockmans and Chisholm in 2000 and AIW in 2002 to focus on food and general merchandise, and didn’t skip a beat – in fact it went on to deliver a decade of record sales and earnings growth.
Woolworths’ most recent major asset sale – apart from Dick Smith – was the $1.4 billion demerger of 69 shopping centres into a separately listed company, now known as SCA Property Group, in 2012.
The success of the SCA demerger appears to have inspired Woolworths and its advisers to weigh up the pros and cons of spinning off BIG W.
While BIG W’s earnings have almost halved over the past five years, falling from $200 million in 2010 to $114 million in 2015, there is a sense that the worst may be over.
THINGS MAY BE LOOKING UP
Same-store sales have fallen for seven consecutive quarters, dropping 8.1 per cent in the September quarter. But Woolworths believes momentum is starting to improve – with the wise hands of Woolworths veteran Penny Winn at the wheel – and is optimistic that earnings will return to growth.
At its peak in 2010 BIG W would have been worth more than $2 billion. It currently has a book value of $1.1 billion and analysts believe it could be worth $1.5 billion if sold.
A BIG W demerger, through an in-specie distribution of shares to existing shareholders, would be more palatable than selling BIG W to the three private equity investors now said to be circling the discount department store chain – Blackstone, KKR and TPG.
If BIG W’s fortunes are improving, a demerger would enable Woolworths shareholders to share in the upside rather than the spoils going to private equity.
No one on the Woolworths board wants a repeat of the sorry situation in September 2012, when Woolworths sold Dick Smith to private equity firm Anchorage Capital Partners for the bargain basement price of $20 million (plus a subsequent $74 million “earn-out”) after failing to turn it around.
Dick Smith was floated 15 months later with a market value of $520 million and Anchorage sold its entire stake last year, netting a profit of $320 million before things started to turn sour.
Dick Smith’s market value has since fallen to $184 million and Forager Funds Management, in a recent analysis, has dubbed the Dick Smith sale and float “the greatest private equity heist of all time”, saying professional and retail investors were fooled. But that doesn’t make it less embarrassing for Woolworths.
The retailer is also red-faced over mounting losses at its big-box home improvement chain Masters.
Conceived in “oligopolitical hubris” (in the words of University of New England professor of management John Rice and Australian National University business lecturer Nigel Martin), Masters has been a disaster for Woolworths, sucking up $2.1 billion in capital, losing more than $600 million over the last four years and failing to meet any of its targets.
Masters is considered by many analysts and fund managers to be unsaleable as a going concern, and will have to be liquidated after losing $245 million last year. It will take years before the business is profitable, even though a new format is delivering stronger sales density.
Estimates of the cost of exiting or liquidating Masters vary hugely, from losses of $900 million to a profit of $1 billion. The variation depends largely on the value of the 33 per cent stake in Masters held by Woolworths’ joint venture partner, Lowe’s Companies.
Lowe’s put option, exercisable from October 20, is in Woolworths’ books as a $886 million non-current liability, but the strike price of the option is based on “fair value” at the time of exercise.
Analysts have suggested that Woolworths would have to pay $500 million to $900 million for Lowe’s stake. But according to Deutsche bank, if Masters was wound up, fair market value would be zero.
Some fund managers believe Woolworths should persevere, saying it would be a tragedy to allow Wesfarmers’ Bunnings carte blanche to increase its already dominant position in the big-box home improvement market. But there is little doubt that Woolworths and its shareholders would be better off without Masters.
Pulling the plug may be one of the first big decisions for Cairns aside from selecting a new CEO.
PETROL ALSO ON THE BLOCK
Another potential asset sale is Woolworths’ petrol business, which accounts for only 1 per cent of earnings but helps to drive sales in the grocery business.
The obvious buyer would be Woolworths’ fuel partner Caltex, which is cashed up and looking for growth opportunities after completing its transformation from fuel refiner to distributor and retailer.
Woolworths does not need to own petrol stations to offer discounted fuel to its loyalty card holders – customers can already redeem Woolworths discount fuel credits at more than 100 canopies that are not owned or operated by Woolworths.
If the petrol division was spun off or sold, Woolworths would simply sign a new loyalty agreement with the owner.
However, some investors believe divesting petrol would make Woolworths’ marketing more complicated and the estimated proceeds of $800 million would hardly be worth the effort.
Woolworths is also selling off its property assets, with at least $400 million of stores and shopping centres up for grabs at the moment.
If Woolworths sold all three divisions, BIG W, Masters and petrol, it could realise between $1.3 billion and $3.3 billion.
The big question is what it would do with the proceeds.
Those who believe Woolworths is starting to look distressed say the money should be used to reduce debt.
According to Citigroup analyst Craig Woolford, Woolworths’ lease adjusted debt to EBITDA will rise to 3.2 times in 2016, exceeding its credit rating range of 2.8 to 2.9 times. This means over $2 billion in debt needs to be repaid to reduce gearing. Dividend cuts are also on the cards.
However, some investors say they would expect some of the proceeds to be returned to shareholders, pointing out that Woolworths does not need the capital and could utilise some of the $1.9 billion in franking credits on its balance sheet to make a tax-effective capital return.
Others believe Woolworths may need to plough the cash into its core food and liquor business to fund an ambitious store refurbishment program and escalating price investment.
Woolworths spent more than $300 million reducing grocery prices over the last six months, but the investment failed to move the dial and same-store sales went backwards for the second consecutive quarter.
The danger is that if Woolworths invests proceeds from asset sales into supermarkets, Coles, Metcash and Aldi will respond in kind. In that case, the only winners will be consumers.