Woolworths and The Claytons Capital Raising - Morphic Asset Management


Happy New Year to all our readers and welcome back, or for those still on the beach– enjoy.


It’s been a busy period for Team Morphic over the Christmas and New Year period. Despite the hopes of some readers, we won’t be delving into the machinations of our previous employer, Hunter Hall, apart from expressing our sympathies to the Unit Holders in the Hunter Hall Trusts and all the shareholders in the company as well as our former colleagues who have to try and work through this period of uncertainty.

There was, however, another relatively large announcement over the short two and half days trading last week involving a company in which we have a position. Woolworths announced that they had sold their Petrol and convenience store offering to BP for $1.8bn.

Superficially this looks like a great result. Analysts had valued the business in the range of $1bn to 1.4bn, based on EBIT of $118m last year, so we were surprised to see how much Woolworths had gotten for the business.

But the devil lies in the detail. On page three of the press release, lies a paragraph outlining some ongoing obligations (highlighting is ours):



Source: Woolworths press release – January 2017

Normally when you sell a business you forgo the earnings, but also escape the costs that goes with that. In this case Woolworths has agreed to keep funding approximately $50m a year in costs into the future at the same time as forgoing the $118mn of EBIT.



Think for a moment that you were looking at buying a house. You bid $1m for the house as that was the guide price. The owner then says to you that if you bid $1.1m they will pay council rates and electricity for you. To work out if it is a good deal or not you add up all the rates you’d pay into the future and discount that back to today, using the interest rate the bank lends you money at. If it comes to a number higher than $100k, it’s a good deal for you.

What Woolworths has done is borrow money from BP using BP’s cost of capital. That is why the price offered is so high compared to analyst expectations. The difference is a capital raising. BP has looked at the offer and decided that offering more cash up front is cheaper than funding those costs over the long term.

The net effect of this commitment is that this is EPS dilutive to Woolworths, so earnings fall even after adjusting for the cash being used to reduce debt.



It does seem all a little odd at first glance. Why not just simply sell the business? One concern we had in Woolworths “event horizon” was that the off balance sheet lease liabilities constrained the businesses ability to change its stores around and close some down.

It meant that whilst a lot of the earnings hits from shutting down Masters and some stores that they announced last year were non-cash charges, they were running quite tight on a cash flow basis. Back in June of 2016, one of the questions we asked internally was perversely “why aren’t more stores being closed?”. Most people thought it was the “big bath” of charges. We thought the opposite: charges weren’t large enough! And the reason they didn’t shut more was the lack of headroom on debt to pay out the onerous lease liabilities.

Which brings us back to this announcement last week. This announcement tells you a lot more about the rest of its business. We believe the firm knows it needs to open up more room on the balance sheet to fund store refurbishments in 2017; to fund price competition (i.e. lower earnings) and to fund more store closures. This is why it’s a “Claytons capital raising”: the capital raising you have when you’re not having a capital raising (some younger readers may need to click on this link). They didn’t want to go to debt or equity markets for the money.

The extra cash doesn’t reduce Woolworths’ fixed charge cover by much (as it now has these costs, it’s taken as a liability), but it does help the Net Debt to EBTIDAR (a proxy for its indebtedness) as can be seen in the JP Morgan table.





A$ in millions
Source: Company records and J.P. Morgan estimates. June year end.


We don’t know that this is the right view of things. 2016 for Woolworths could be looked back as a year where the bulls took charge enough to stop the price falls and enough people become convinced the turnaround was well underway. If our view is right, we should expect to see weaker EBIT results in February as being reflective of the high cost of getting sales growth back on track. We should also see in the cashflow larger than expected CAPEX plans.

Nothing that we have seen in the market suggests that price competition is abating.

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