With Standard & Poor’s placing Woolworths on “negative credit
watch” amid concerns the ALH takeover bid could turn
hostile, the Woolies board and Roger Corbett must prepare for the worst
– a rating downgrade bringing Woolies down ever closer to rival Coles.
It must be an unusual situation for Woolworths CEO, Roger Corbett and
the board led by chairman James Strong, a ‘credit watch negative’ from
a rating agency is not the sort of shot across the bows that the
country’s most aggressive retailer is used to.

In fact, as the coat tuggers and urgers in the market and among the
various self-interest analysts and advisers whisper stories about what
Woolies and its friends will or won’t do, the S&P statement
provides the Woolies board and shareholders with a warning of potential
damage to its jealously held A minus credit rating.

Coles is a triple B rating (probably heading higher) and any downgrade
of Woolies to a single A, or even lower would be mortifying to the
board and Roger Corbett.

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And it should also be a timely reminder to the Woolies board that there
will be a financial cost to the grandiose ambitions for quick
domination of the liquor market via the replication of the Queensland
methods of an off balance sheet joint venture on a national scale
through the advance on Australian Leisure and Hospitality (ALH).

Standard & Poor’s said Tuesday that it had placed Woolworths on
‘negative credit watch’ amid concerns the takeover bid could turn
hostile and is coming at a time when Woolworths is undergoing a
significant restructure of its own.

Standard & Poor’s said it “expects that a potential bid for ALH
could increase Bruandwo’s (the Woolies stake with its Queensland
partner, Bruce Mathieson) stake to a controlling interest in, or even
full ownership of ALH. Moreover, it is possible that any such bid might
become hostile if ALH management did not fully endorse a Bruandwo
offer, or if a third party made a bid for ALH. Although Woolworths has
some debt capacity to fund such an acquisition (if one succeeds),
Woolworths’ credit metrics could come under pressure, depending on the
final price, associated debt burden and structure of the transaction.”

“Even though the transaction would expand its highly successful joint
venture with BMG in Queensland, the ALH acquisition is likely to
increase Woolworths’ leverage (including the use of off-balance sheet
operating leases), particularly given Woolworths’ record of using debt
to fund acquisitions. Integration risk could also pose short-term
challenges for management. Furthermore, the transaction comes as
Woolworths is implementing a major restructuring of its supply chain
systems and processes, which itself poses large funding requirements
and significant execution risk. The company is also facing heightened
competitive pressure from a reinvigorated Coles Myer Ltd and slower
retail sector growth rates.

Resolution of the CreditWatch will be determined as more details of the
transaction emerge. Key to resolving the CreditWatch will be the final
cost and the overall structure of any transaction, and any additional
debt burden Woolworths assumed to fund the acquisition.

Any bid from Woolies and Bruce Mathieson and their mate in Queensland,
Andrew Griffiths would have to be around $1.1 billion or more to win
ALH.

At this level, as S&P has pointed out it would be a big bite, even
for Woolies with its undergeared and very strong balance sheet, despite
the blithe dismissal of such a deal by analysts like Macquarie, which
of course has ‘form’ in the history of ALH.

Macquarie pointed to the ease with which Woolies could fund the bid off
its strong balance sheet, which it could, but the question for
shareholders is, does it want to move deeper into hotels, even
indirectly, when its own retail business is slowing and countering the
reinvigorated Coles Myer is proving tough?

Macquarie also has shares in ALH, so the comments about the ease in
which Woolies could bid, must be taken with a grain of salt and looked
at as being completely self-interested and an attempt to talk up the
market to take Macquarie out at a fat profit on the $2 a share they and
four institutional ‘mates’ paid for their ALH shares last year.

But what all these analytical giants haven’t touched on is how Woolies will handle the bid and the timing.

For example, why was the bid revealed on the first day of the new
financial year, last Thursday? Does have anything to do with the way
Woolies currently doesn’t consolidate its Queensland hotels adventure
with Mathieson and his mate, Andrew Griffiths in MGW Hotels?

Woolies has 12 months to do a deal for ALH, fix up the accounting side
and pretty up the balance sheet and make a decision about consolidation.

S&P is awake to that trick and has effectively blown’ the whistle’ by putting the retailer on a possible downgrade.

It is now up to Woolies’ management and board to convince the agency
and shareholders that the deal will be done in such a way to put as
little strain as possible on the balance sheet. It will mean
being up front rather than secretive. Woolies owns 50% of MGW in
Queensland and claims that it doesn’t need to consolidate the assets
and liabilities, sales and earnings because MGW is “not a controlled
entity” within the meaning of the phrase in the Australian Accounting
Standards.

That’s roughly $300 million of assets, and presumably similar
liabilities off balance sheet in around 100 liquor outlets and 30-odd
hotels. In terms of the size of the Woolies balance sheet, that’s
not a big deal, although the structure of MGW must be very interesting
to allow Woolies and its auditors to sign off on the non-consolidation.

Woolies would have to be a passive investor in the joint venture, with
control and voting power residing with the other two partners.

In contrast the Woolies-Caltex petrol joint venture is consolidated because Woolworths is in a position to control it.

But with the growing size of its investment in hotels, can Woolies
continue to allow MGW for example to remain unconsolidated and not even
equity accounted?

That’s a question for the 2004 annual report and auditors Deloittes.

Not consolidating more than a billion in off balance sheet financing
and assets, with some goodwill and uncertainty attached to it, might be
a bigger test for the board and the auditors, and big investors.

There’s plenty Woolies and its partners can do. A bid can be made for
ALH, and the MGW business can be back into it as a restructuring of the
various interests and a sorting out of equity and debt.

That would seem to be cleaner and more sensible, with Mathieson and
Griffiths taking over the running of the hotels side and the gaming
machines, with Woolies handling all the liquor outlets.

But there would have to be sorting of out some conflicts of interest.
For example, every drink sold by Woolies is potentially one less drink
sold inside the hotel and profit to the hotel operators. And the
reverse applies, with Woolies missing out.

In Queensland hotel licences cannot be split from the business, meaning
Woolies cannot do anything ‘creative’, without the Beattie Government
signing off on the idea.

Its still early days, But Woolies board and CEO Roger Corbett have had
a warning from S&P that being too cute and too clever will be
costly.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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