Analysts Corner: Whitbread

Laith Khalaf, senior analyst, Hargreaves Lansdown, said that “coffee shops are hotel rooms don’t make natural bedfellows”, therefore it makes sense to split Costa Coffee from Premier Inn.

“The break-up will provide each of the two emerging companies with greater strategic focus on their own goals, and will allow investors to choose which of the two distinct brands they actually want exposure to,” he said.

However there are issues to be addressed, such as the pension scheme and the process of setting up a separate board, though the 24 month target for the demerger allows plenty of time for these matters to be resolved, added Khalaf. “The split could also ultimately lead to a shake-up of the top brass at Whitbread, unless the executives are willing to accept the reduced earnings potential running a smaller company probably entails.

“The question will of course arise over whether CEO Alison Brittain jumped or was pushed into this proposal by the arrival of two activist investors on the shareholder register. The reality is this is a rather moot point for investors as the demerger is now firmly on the table, one way or the other,” continued Khalaf.

“Elliott and Sachem Head will no doubt still try to influence proceedings, particularly in respect of the timing of the split, as two years is longer than they would have wanted for the deal to be completed. Indeed the fairly lengthy timeline looks very much like Whitbread’s attempt to maintain control of proceedings. In essence management has agreed to go with the flow, but isn’t relinquishing command of the vessel.”

Following Whibread’s conference call with investors yesterday, Rachel Fox at Goodbody, noted that both Costa and Premier Inn continue to see weakening underlying trends, “and there appears limited scope for this to improve in FY19”.

“In fact, Costa KPIs could weaken further. In addition, incremental investment has been earmarked for Costa. However, the increased cost efficiencies are helping to offset these issues, along with continued cost inflation, and we are likely to keep our FY19 forecasts unchanged,” she said. “We currently forecast FY19 EBIT of £620m and expect consensus (£649m) should drift down towards this.

“In terms of the demerger, this announcement is not surprising given recent speculation and shareholder support for a split of the group,” added Fox. On the 24-month timeline given for the spin off she said that given the recent soft performance in Costa and the lacklustre performance in its international business to date, whether the business could achieve any form of premium multiple in the short to medium term was hard to gauge.

“When asked about the timelines management highlighted reasons that it will not be easy to separate the two businesses. These include: (i) both businesses are supported by the same infrastructure; (ii) the pension liability of c£300m will need to be negotiated; (iii) debt currently sits with at a corporate level and will need to be separated; (iv) there are c1,000 people working in shared services (IT etc); and (v) they currently have c2,000+ suppliers and are committed to executing on its cost efficiency programme,” said Fox.

“When asked about the additional costs associated with running Premier Inn and Costa separately, management did not quantify this but did guide it would be in the “low tens of millions”. The demerger is currently at the start of the planning phase and management will update the market as it progresses.”

Fox said performance at Costa continued to be impacted by high street store weakness. “Costa equity store LFL sales were -1.8% in Q4, given its heavy weighting towards the high street where footfall has been declining c.3-4%,” she said. “As these footfall declines are expected to continue into FY19, Costa LFL sales growth will continue to remain in negative territory.

“While there have been no cuts to coffee pricing in the face of competition management is aware that value has become a bigger component of the market and Costa is now doing value offers/bundle deals with food and coffee. Management also noted that food LFL sales were positive in Q4 and food capture rates have been improving (+1 ppt) as Costa rolls out new products and improves its customer proposition.

Looking at the overall coffee market, Fox noted that coffee consumption CAGR is forecast to be 10% between 2017 and 2022. “In terms of new openings, the group is focussing on expansion in travel hubs and drive-thru in order to diversify its portfolio away from the challenged high street and shopping centres,” she said. “There will also be a continued focus on the rollout of Costa Express machines (1,300 in FY19), which is arguably one of the best performing divisions of the enlarged group, with mature machines generating a return on capital in excess of 35%.”

Jamie Rollo, of Morgan Stanley, posed some key questions for investors

1. Why could a demerger take up to 24 months? Can the company give more detail on the timing and quantum of the action it is taking on technology and efficiency to give a sense of when they will be complete? Is the company giving itself time to turn around the business, and/or take part in industry consolidation?

2. Would Whitbread consider selling Costa as an alternative? Has it received any interest? How would it evaluate offers, and how does it value Costa as a demerged entity?

3. How should we think about the allocation of debt, pension deficit, and PLC costs between the businesses? Are there any friction costs such as additional central costs or tax?

4. What would management’s response be to additional activist demands such as operational improvements, or real estate disposals?

5. Why were Q4 LfLs negative despite a robust economy? What does this imply for the company’s sales performance in the next downturn? Are there any further efficiency gains that could be gleaned?

6. How would the company respond to a downturn in the UK economy and/or a ‘hard’ Brexit? Might it consider slowing the pace of expansion in either hotels or coffee shops, given it is cannibalising itself? Would it consider buying back shares or increasing its dividend more if it stops expanding and FCF improves materially?

7. Why did Costa’s LfL sales weaken to -2% in Q4 despite the easier comp and benefit from its food offer? The company saw encouraging growth in its new food lines, but high street footfall weakened, so can it break down LfLs between newer and mature stores, food and drink, High St vs other? What is management’s view on when LfL sales might turn positive?

8. What is the scope to expand Costa Express (machines) into other UK markets (e.g. corporate vending) and overseas? What are the economics of UK vs international machines? Why did the company pull out of Canada?

9. Why is Costa China still loss-making and when is it expected to break even? How confident is it in its target of 1200 stores by 2020, given it missed its 2016 target of 500 and 2018 target of 700 (450 currently)? With £5m additional cost going in this year, and a changing mix to less profitable stores, how confident is it in its target for £20-25m EBIT from Costa International?

10. In hotels, how will the company cover its WACC on the recent £250m Foremost deal. We estimate PI generates ~£3k EBIT/leased room in the UK, implying a <3% ROCE on the acquisitions ~3k leased rooms. How much capex does it need to invest at its target 10% ROCE in order to meet its WACC overall in Germany?