EUR 850.00 For Business Accounts Only

Morningstar | Coles' Reported Attempt to Exit Its Pub Business Drives a Reduction in Hotel Property’s FVE. See Updated Analyst Note from 31 Dec 2018

A change in analyst prompts a reduction in narrow-moat Hotel Property Investment’s fair value estimate to AUD 3.05 per stapled security from AUD 3.40. The reduction is driven by the risk that Coles will circumvent Queensland’s restrictive liquor licensing legislation, enabling it to exit its pub business. The defensive characteristics of inflation linked rents, restrictive liquor licensing laws, and investment-grade tenant in Coles are the main reasons to invest in Hotel Property. However, there are growing risks to these defensive characteristics. At our new fair value estimate, it trades on a fiscal 2019 price to fund flow from operations of 15.1 times and distribution yield of 6.5%.

If Coles can extricate itself from its pub business by circumventing Queensland’s licensing laws, Hotel Property may not only lose an investment-grade tenant, but the value of its commercial hotel licenses is likely to fall. Coles is undertaking a strategic review, including a potential transaction that, if successful, would lead to the economic separation of its liquor and gaming revenue. Coles has not revealed details on this transaction, but media speculation points to Coles attempting to circumvent the Queensland licensing laws by entering into a synthetic joint venture with firm Kohlberg Kravis Roberts, or KKR. KKR will receive earnings from the pubs and Coles from its liquor stores. It appears to us that Coles is seeking to remove the potential reputational damage of continuing to be a poker machine operator via its pub businesses.

While there is uncertainty whether this deal will complete, it confirms Coles' desire to get out of operating poker machines, which is a key earnings driver of its pub business. Coles is likely to want to retain its valuable liquor business. However, Coles' liquor business only represents about 9% of its operating earnings, and even if Queensland laws do not change and it’s unable to circumvent them, there is a risk that Coles will decide the reputational risk of operating poker machines outweighs the earnings from its liquor business.

If Coles did not renew its leases, there is a reasonable prospect for Hotel Property to find alternative tenants although maybe not of the same quality as Coles. There are also no material lease expiries until 2021. Transaction evidence points to Hotel Property being able to realise good selling prices for most of its pubs. Although most of its pubs are in regional areas, pub real estate in general has been selling on historically low capitalisation rates (yields) and it’s been a net seller in this market, focusing more on developing existing properties and moving into the adjacent business of hotel accommodation. Despite these potentially mitigating factors, there are genuine risks to its otherwise defensive traits.

These defensive features are a key rationale for investing in the security. Since rents are not linked to pub earnings, this means investors do not benefit from the upside of stronger pub operating performance and have the downside risk of the tenant not renewing leases on poorly performing pubs. The trade-off that is attractive to many investors is the defensive nature of the long lease terms to an investment-grade tenant that generate above-inflation rental increases with low maintenance costs due to the triple-net leases. Consequently, a risk to these defensive features has the potential to impact Hotel Property’s primary investment rationale.

The restrictive liquor licensing regulations in Queensland also provide it with a valuable intangible asset because it’s the ultimate holder of commercial hotel licenses on most of its properties. These licenses allow the holder to sell liquor at up to three detached bottle shops within 10 kilometres from the main premises and such sales are not permitted without a hotel license. Licenses revert to Hotel Property at the end of the lease term with respect to most of its pubs. Moreover, where Coles owns the license but terminates the lease, Hotel Property has first-right-of-refusal over the license at a pre-set price tied to trading data at that time. However, if Coles can circumvent Queensland’s restrictive licensing requirements and sell liquor at detached stores without operating a pub, it may negatively impact the value of Hotel Property’s commercial licences.