On 6th December 2017, Whitbread became one of those companies when US-based hedge fund, Sachem Head, took a 3.4% stake (albeit through derivatives) and demanded a break-up of the FTSE 100 giant.
Activist investors, like Sachem Head, differ from active investors like JM Finn, who differ from passive investors like index tracking funds. We at JM Finn will consider management’s ability and decision making in creating shareholder value and subsequently choose whether or not to take or maintain an equity stake. However, activist investors will take a large stake with the aim of obtaining a board seat and ultimately forcing change based on their shareholder value creating ideas from within a company.
As part of their investment in December, it was reported that Sachem Head are pushing for Whitbread to spin off one of their two major brands with the sale of the Costa Coffee business. This came alongside calls for Whitbread to employ a wide scale ‘sale and leaseback’ in order to reduce their proportion of freehold estate within Premier Inn, therefore freeing up cash for shareholders.
Costa makes up around 40% of revenues for Whitbread, whilst Hotels & Restaurants makes up the remaining 60%. Hotels includes the brand, Premier Inn. The smaller segment, Restaurants, includes brands such as Beefeater Grill and Brewers Fayre. Costa, with coffee shops both in the UK and overseas, has a multi–channel strategy, with self-service coffee machines, equity stores, franchise stores and stores operated as joint ventures, as well as a wholesale operation.
Where Whitbread has previously enjoyed an extended period of double-digit growth in its two major brands, recent updates have shown slowing like-for-like sales which are being boosted by, arguably more expensive, capital expenditure (capex) heavy growth as Whitbread increase their footprint across high-streets, petrol stations and overseas locations.
Against this backdrop, we believe that management will need to report one or all of three things to keep the activists at bay – increased underlying growth from the Costa brand, an obvious advantage from their mostly freehold model at Premier Inn and/or greater evidence of the mutual benefits coming from keeping these two brands as part of one corporate entity.
There is the well discussed argument that recent UK inflation, alongside stagnant wages will squeeze the consumer, thereby reducing discretionary purchases such as their 'grande-soy-macchiato with a vanilla shot'.
Taking these points in turn, we are firstly concerned that underlying growth is likely to remain challenged at Costa. There is the well discussed argument that recent UK inflation, alongside stagnant wages will squeeze the consumer, thereby reducing discretionary purchases such as their ‘grande-soy-macchiato with a vanilla shot’. However it is Costa’s position in an already competitive market that could be considered a further cause for concern. Whilst artisanal coffee shops have grown market share through a differentiated proposition, pricing pressure has come from the value end where the likes of Greggs and McDonalds have invested in their coffee offerings.
As part of a sale-and-leaseback, management would free up cash which they could choose to return to shareholders or use as part of their global growth strategy. Although we see operating efficiencies from this capital light model we would be wary of some of the longer term drawbacks which could come in the form of worse future lease terms, an inability to benefit from capital gains on their existing freehold portfolio and a lack of control of assets. However, of particular note would be the increased operating leverage within a cyclical business during a time of macroeconomic concern.
With regards to the mutual benefits of the two brands being run together, we can understand both sides of the argument. Whitbread management might argue that their leisure sector expertise means that they are best equipped to run both brands, whilst the activist investors would say that with little obvious cost or revenue synergies from the businesses, their marriage only serves to add layers of management and the cost and inefficiency that goes alongside.
Following three months that pose more questions than answers, we now have another variable to add to the mix. In my opinion, a sum- of-the-parts valuation implies some upside, whilst a discounted cash ow (DCF) valuation could suggest some cause for concern but with so much uncertainty in the outcome of Sachem Head’s recent raid what is the best way to value the existing business?
In a recent edition of Prospects, we argued that valuing Whitbread ’revolves around understanding if and when the company goes cash flow positive and to what extent’ (Prospects, Winter 2017). Recent moves from Sachem Head though have caused investors to consider an alternative, ‘sum-of-the-parts’ valuation. On this basis, we might consider Costa’s earnings relative to Starbucks’ valuation, Premier Inn’s proportion of profit relative to Accor’s valuation and the Restaurants’ earnings relative to a selection of UK PubCo’s ratings.
So with all of this in mind, we must now consider what the most likely outcome for Whitbread is and how to value the company from that point. A Sachem Head style break up could see short-term upside but longer-term operational risk. Whereas the continued running of the business in its current form leaves little cash ow to shareholders at present, but a hope that the business will turn cash ow positive (post capex) in the medium-term, with comparatively less operational risk.
Perhaps the question to shareholders is which would be the lesser of two evils?
