EUR 850.00 For Business Accounts Only

Morningstar | Hotel Property’s Moat Rating Downgraded on Uncertainty About Coles’ Pub Strategy, But FVE Unchanged

Uncertainty as to Coles’ long-term strategy with respect to its pub business prompts a reduction in Hotel Property Investments' moat rating to none from narrow, but its fair value estimate is unchanged at AUD 3.05 per security. We believe Coles would prefer not to be in the business of operating pubs due to their reliance on poker machine revenue. Nonetheless, Coles will need to retain these pubs in order to maintain its liquor retailing business under Queensland’s restrictive regulations, which require organisations to hold a commercial hotel licence to operate liquor stores. Therefore, our base case continues to assume most of the circa 40% of Hotel Property’s leases up for renewal in 2021 will be renewed. However, given the uncertainty over Coles’ strategy regarding its pubs, and the potential negative impact on lease renewals, rental income and property valuations, we don’t have enough conviction that over the long term Hotel Property will be able to generate returns that exceed its cost of capital to be confident it has a sustainable competitive advantage.

We expect Coles would prefer not to be in the pub business because of the potential risks to its reputation for being associated with poker machines, combined with the fact that these earnings only represent a small portion of Coles' total operating earnings. We think this is the main reason Coles is currently undertaking a strategic review of its pub business, including a potential transaction that would lead to the economic separation of its liquor and gaming revenue. We think recent public comments by Wesfarmers managing director Rob Scott that Coles is looking for a structured exit of its pub business (Sydney Morning Herald, Sept. 4, 2018) supports our view.

We expect Queensland’s restrictive liquor licensing law is one of the main obstacles preventing Coles from exiting its pub business. A commercial hotel licence must be held to sell liquor at a detached bottle shop in Queensland, with the holder able to sell liquor in up to three detached bottle shops within 10 kilometres from the main commercial premises under the licence. Most of Hotel Property’s portfolio of pubs are in Queensland, and it retains the commercial licences of most of the pubs. These licences revert to it at the end of the lease terms and Hotel Property has the option to purchase other licenses used in respect of the pub operations.

We also expect Coles would want to retain its liquor retailing business. Australian liquor sales have proven to be resilient to the economic cycle, growing by a CAGR of 7.2% in Australia over the last 33 years between June 1985 and June 2018. But Queensland’s restrictive regulations prevent Coles from separating their pub businesses from their bottle shops because they need the commercial hotel licence to operate liquor stores in Queensland. We expect Coles would be likely to divest its pub businesses if Queensland laws were changed to permit this. However, the Queensland government have not indicated they are considering such a change in law and we think there would be significant lobbying against the decision if it were proposed.

Therefore, our base case continues to assume Queensland licensing laws will not be changed. In turn, we continue to expect most of circa 40% of Hotel Property’s leases up for renewal in 2021 will be renewed, as Coles will still need its hotel licences to operate its liquor stores. Nevertheless, we believe Coles will be less inclined to renew leases at poorly performing pubs in areas where growth in liquor store sales are expected to be relatively low. We also believe Coles will have less incentive to invest in developing existing pub properties relative to other more core parts of its business. For these reasons we don’t have enough confidence that over the long term Hotel Property will be able to generate returns that exceed its cost of capital to warrant a narrow moat rating.