Endeavour Group will be a BUY

Co-founder of the Switzer Report
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If Endeavour Group (EDV) follows the way of most demerged companies, it will be good buying at some stage. That’s if you are not put off by the ESG (environmental, social and governance) concerns.

Endeavour Group commenced trading on the ASX last Thursday. It has been spun out of Woolworths, and comprises the Dan Murphy’s and BWS retail drinks businesses and a hotels business known as the ALH Group.

Demerged companies have a good track record in Australia. Names such as Coles, Treasury Wine Estates, BlueScope, Orora and S32 readily come to mind. The idea being that a refreshed and incentivised management team, free from the shackles of the former head office and with access to their own balance sheet and capital, is able to drive the company to a higher level of performance.

But it takes time, so the market takes a while to recognize the progress the company is making. Further, when it lists, there is an absence of a compelling reason for fund managers to buy. There are also good reasons for shareholders to sell, who suddenly find themselves with shares in a company they don’t really want exposure to.

So the typical trading pattern for a demerged company is that it does it tough on the ASX for a few months as sellers take the upper hand, before attracting fresh institutional buyers. Over 12 to 18 months, investors usually enjoy solid returns.

If the first couple of days of trading in Endeavour is anything to go by, it is following the script. It debuted at a much lower price ($6.50) than many had been predicting (including myself), fell as low as $5.77 before recovering to close at $6.02. On Friday, it opened higher at $6.23, traded up to $6.60 before falling away to close at $6.10.

At $6.10, Endeavour has a market capitalisation of $10.9bn and an enterprise value of $12.2bn. The latter is considerably lower than the pre-listing estimates of up to $15bn, and illustrates the big discount being applied due to ESG concerns. As the operator of 332 licensed venues, Endeavour is also Australia’s largest owner of electronic gaming machines (poker machines) with 12,364.

The ownership of poker machines is primarily why Woolworths demerged the Endeavour business. Woolworths Directors were tired of being “beaten up” by activists at AGMs. More importantly, they knew that some fund managers had taken Woolworths of their buy list because of ESG restrictions.

Endeavour now faces these issues but in an even more concentrated way because it is 100%  “alcohol and gaming”. And as we have seen with the coal miners, there are more and more investors reviewing stocks through an ESG lens.

However, there will be buyers at the “right price”, including income investors who are attracted by a relatively secure dividend. More on this later, but first up, a review of the business and then what the brokers have to say.

The Endeavour Group’s business

Endeavour comprises the following:

  • The #1 and #2 preferred retail drink brands in Australia through Dan Murphy’s and BWS, which operate the largest network of 1,630 stores. Estimated 40% market share;
  • Largest hotels’ network in Australia with 332 hotels (49 owned, 283 leased on long term leases). In relative terms, this is potentially (post Covid) the most profitable part of the business;
  • 1,775 liquor licenses and 12,364 poker machine licences;
  • Specialty businesses Langton’s, Cellarmasters, Shorty’s Liquor and Jimmy Brings;
  • A products and services capability through Pinnacle Drinks (wineries and wine services); and
  • Strong digital presence (apps, online sales etc) and 5.1m My Dan’s loyalty members.

In FY 20, Endeavour Group generated a proforma EBIT of $693m and NPAT of $328m on revenue of $10.6bn. This was heavily impacted by Covid-19, with the retail businesses seeing strong growth in sales, and hotels hit by lockdowns and government restrictions. On a per share basis, the earnings were 18.3c.

Pre Covid, NPAT was $445m in FY19 on sales of $10.3bn, or 22.5c per share.

Looking ahead, and assuming that the Covid impact has largely gone, the market is expecting an NPAT of close to $500m in FY22 (which commences on Thursday). On a price of $6.10 and earnings per share of 27c, this puts Endeavour on a PE of 22.6 times.

In terms of growth, Endeavour operates in low growth markets. Pre Covid, retail liquor industry revenue in Australia had a CAGR (compound annual growth rate) of 3.0% pa. Hospitality industry revenue was largely flat. Offsetting this is that industry revenues are not volatile, meaning that barring an unforeseen “black swan” such as Covid, Endeavour’s revenues and earnings are relatively predictable.

Endeavour says that its strategy for growth is:

  • Growing digital engagement (lifting ecommerce share, make digital the front door to all brands including hotels);
  • Strategic expansion of the network (roll-up and development of new hotels etc);
  • Enhancing the existing footprint, particularly hotel refurbishments;
  • Expand product range and reach – leverage Pinnacle Drinks to support new category growth and support premiumisation; and
  • Enhance end to end efficiency.

With strong operating cash flow to support capital expenditure of circa $325m and access to debt facilities of $2.5bn, Endeavour says that it is targeting credit metrics consistent with “an investment grade” profile. It expects to pay a dividend of 70% to 75% on NPAT, which should be fully franked.

What do the brokers say?

Broker research is still being published, but here is a precis of two opinions.

Morgan Stanley says that based on the current share price of $6.10, Endeavour is trading on a 22.6 multiple of forecast FY22 earnings. It says that this is a 25% discount to the average PE for the S&P/ASX 200 Industrials ex Finance group. It forecasts a dividend yield of 3.3%.

Jefferies has initiated coverage with a “buy” and a price target of $7.00. It sees scope for Endeavour to expand its hotel operations through acquisitions now that it has been separated from Woolworths. It says that the Group has sufficient cash flow to make 10 to 20 acquisitions of hotels each year without increasing debt. (Pre covid, Hotels were  more profitable than the retail businesses based on the EBIT margin). For FY21 (which finishes on Wednesday), it forecasts total revenue of $11.56 bn and NPAT of a minimum of $450m.

My view

If you aren’t put off by the ‘alcohol and gaming’, there is a lot to like about Endeavour from a financial perspective. An undemanding PE, attractive fully franked dividend yield of around 3.5%, and in a post Covid world, very stable and predictable earnings. It is the market leader. Plus, the management team will get a real shot at growing the business, with hotels and digital the key priorities.

The questions we don’t have answers for are how big the ESG discount is, and with lockdowns threated in at least four states, the ongoing impact of Covid-19 on the business.

This is the way I intend to play Endeavour. I am going add to my holding from the demerger around the $6 level, and then over the next couple of months, look to build on this if it dips into the 5’s either due to market weakness or just the normal overhang of selling from the demerger.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.

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