Tough choices for Woolworths as David Jones threatens domino effect
Investors last heard from Woolworths on July 24. No earnings guidance was provided but the statement did reassure investors that “actions taken have ensured that the balance sheet remains robust”.
We believe the complexity of dealing with the deteriorating David Jones situation in Australia is not fully appreciated.
The failure of David Jones could trigger the failure of Country Road Group (CRG), which could then possibly affect the equity of the holding company in SA. The genesis of this domino effect is the “common terms deed”, referred to in the 2017 annual report, which links the fortunes of David Jones and CRG. Entering this agreement was the “original sin” and it presents a significant risk.
Acquired in 2014, David Jones has declined dramatically, and Woolworths has been forced to write down the A$2.2bn (R27.5bn) investment twice, first by A$712m in 2018, and again in 2019, by A$437m.
Woolworths needs to get the lenders to terminate the “common terms deed”, where the assets of the CRG and David Jones together guarantee the Australian debt. Otherwise the failure of David Jones could take the CRG into administration along with it. A write-off of Australia then risks eliminating a material portion of the equity in the SA holding company, this despite the remaining SA operations being high-quality, profitable and very cash generative.
What is the issue? From the segmental information provided in the group’s interim accounts, the carrying value of the
Australian assets is R10.7bn (R6.9bn and R3.8bn for David Jones and CRG, respectively).
Deducting the amalgamated and insolvency-remote Australian debt of R3.8bn (A$379m) gives a combined equity value of R6.9bn.
However, the carrying values of the investments in the company’s accounts are not the same: at the company level, the carrying values reflect the initial cost of those investments on acquisition, less impairments and other fair-value adjustments. In 2019, a subsidiary called Woolworths International Holdings Limited (WIHL, an intermediate holding company of CRG) declared a dividend of R10.7bn, replenishing the reserves of the holding company that had been depleted by David Jones impairments of R11.4bn.
The WIHL dividend was settled “in-specie” by way of transferring shares in its own subsidiary, Highway Holdings. It appears the reserves of Woolworths Holdings Limited (WHL) were replenished by the revaluation of CRG in the company’s accounts via intermediate holding companies.
There is nothing untoward about this transaction and it did not bolster the group’s consolidated earnings. But the reserves of WHL were effectively replenished by the revaluation of CRG.
The company’s reserves are now possibly under risk of impairment — with the carrying value of the CRG structure now revalued. The company has reserves of R12.6bn against its Australian investments carried at R19.2bn: David Jones at R7.6bn and CRG of R11.6bn.
Breaking the common terms deed is imperative to protect CRG and avoid any potential impairment. To get banks to agree, Woolworths would probably need to settle the debt, which stood at A$464m in December 2019 (A$379m net of cash balances).
The A$121m from the recent sale of Bourke Street, together with the sale of the distribution centre, might reduce the debt to about A$150m. Some investors believe a sale and lease back of the Elizabeth Street property would cover the balance. We think this unlikely. It has a distressed, single-tenant occupant, no parking and redevelopment “air rights” if a buyer were looking beyond the current tenancy.
OTHERWISE THE FAILURE OF DAVID JONES COULD TAKE THE CRG INTO ADMINISTRATION ALONG WITH IT
BREAKING THE COMMON TERMS DEED IS IMPERATIVE TO PROTECT CRG AND AVOID ANY IMPAIRMENT
There are no good alternatives available. The answer may be for the SA holding company to inject more cash into Australia. This investment would probably need to be impaired immediately. But it would avoid losing CRG and preserve a large portion of the group — and perhaps more importantly — the company’s equity.
Clearly the issue is complex. It must be a situation the board would be keen to resolve. We suspect a rights issue is required, but it’s hard to know for sure. It is surprising that the company has not yet been able to conclude that earnings will be down more than 20%.
All Weather Capital does not have any position in Woolworths.