The Investment Opportunity
Endeavour Group (Endeavour) operates in the competitive market of retail liquor. In this market pricing power is absent and competitors compete on price for an increased share of volume. The result is that the key driver of the group’s profitability and return on invested capital is sales volume, also seen as market share.
The group will be demerged from Woolworth’s and listed on the 1st of July 2021. Once independent the group plans to continue to increase the range and penetration of its private label products. The higher margin of private label products allows the group to offer market leading discounts whilst maintaining stable gross margins. The discounts on private label sales will allow Endeavour to further grow sales volumes and hence increase the groups profitability.
The market is missing this growth simply because it is incredibly hard to spot day to day. Private label liquor is unique in the fact that consumers are not aware they are purchasing private label. A favourable market structure and a set of idiosyncratic attributes the group possesses sees it best placed to use private label products to further drive down prices over the long-term. The driving down of prices will lead to increased market share and profits driving Endeavour’s share price higher.
Endeavour is the make-or-break Australian distribution partner for liquor producers. The group represents ~40% of retail liquor distribution in Australia. It has no competitor of similar size. The remaining market share consists of independents and Coles with ~12% and ~14% respectively, and the rest being shared by Aldi, Metcash, pub bottle shops and wine subscriptions.
The market is characterised by countless suppliers, incredibly low brand loyalty and diminishing barriers to entry with advancements in canning and bottling technology. Combining the concentration of market share Endeavour has captured, and the weak bargaining power of its suppliers, compounds the bargaining power Endeavour enjoys.
These characteristics are all well known to market participants, but there is a key business of Endeavour that the sell-side, buy-side and consumers have barely noticed. This business is Pinnacle Drinks, a wholly owned subsidiary, and it capitalises on the above-mentioned market structure to strengthen Endeavours offering of an extensive range of low-cost liquor.
The Australian retail liquor industry is at the precipice of an immense structural shift towards private label products, and consumers and investment analysts (large overlap) have barely any idea.
Pinnacle Drinks (Pinnacle) “partners with winemakers, growers, brewers and distillers to deliver…brands to BWS, Dan Murphy's and The ALH Pub Group”. Pinnacle engages in the procurement and branding of liquor products via the outsourcing of the majority of the production and bottling process. Products are then sold under indistinguishable private label brands throughout Endeavour’s 1,962 outlets Australia wide. Many in the industry refer to the products as “phantom private label” due to the fact consumers are oblivious to the fact that they are purchasing private label.
These products cost Endeavour a lot less than those from branded suppliers and is why they are Treasury Wines, Accolade Wines, CUB, Diageo, and any other supplier to Endeavour’s worst nightmare.
The primary value proposition of Endeavour is that it sells a wide range of cheap liquor, attracting customers and keeping them coming back. Hence, Pinnacle is not a mechanism for margin expansion at Endeavour, but to further increase Endeavour’s market share and turnover with unbeatable prices and range.
Cost of Growth
Whilst already large Endeavour still has plenty of room to run. Coupled with the ramping up of Pinnacle is the fact that store expansion for Endeavour is a much less capex intensive task than the expansion of supermarket stores.
The reason for the reduced capex requirements is simply due to refrigeration requirements. Supermarket stores require significantly more front-of-shop refrigeration, whilst also requiring back-of-shop refrigeration to keep inventory from spoiling.
In contrast, both BWS and Dan Murphy’s require no back-of-shop refrigeration whilst also requiring significantly less front-of-shop refrigeration. For its part, a Dan Murphy’s store, through which the majority of Endeavour’s retail liquor sales occur, is more or less a bare-bones warehouse with portable shelving, polished concrete floors, and a cool room in the back corner.
In summary, growth will be cheap from a capex perspective with a trailing 5-year average of capex to revenue of sub 2%. Additionally, Endeavour will no longer have to compete within the same budget as the more capex intensive supermarket stores.
The below is a rough relationship between store openings and capex, obviously there is a large difference between a Dan Murphy’s and BWS store as well as capex spend on store refreshes. What it does show us though is that the coefficient of capex per store openings has never varied significantly from the 5-year average of $4 million.
What this implies is that stable gross margins and increased revenue have not required a higher level of investment in operating assets. This is also seen in the ratio of capex to revenue for Endeavour Drinks below, which is on average a third lower than the supermarket business:
Endeavour also enjoys favourable terms with suppliers. Typically, payment terms are between 60-90 days whilst days sales of inventory (DSI) on hand is just over 60 days. The net effect is that Endeavour enjoys a negative working capital balance. This reduces the cost of growth as inventory can be sold before it is paid for, and the business can expand its market share without needing the injection of any external cash.
The Consumer Experience
High private label penetration is nothing new to the Australian retail landscape. With the likes of Woolworths, Coles and particularly Aldi having significant private label penetration amongst their shelves. In contrast to the FMCG retail experience, however, is the fact that individuals are unlikely to realise that they are purchasing private label liquor. This is simply a product of lower brand recognition in the liquor retail market, with individuals mainly shopping by variety and price, though there are exceptions.
Below are the product pages of two Pinnacle private label products currently being sold at Dan Murphy’s:
Ci-Fi - Craft Cider (Barossa):
Cat Amongst The Pigeons - Fat Cat Shiraz (Barossa):
Now, there is no immediate indication the brands you are purchasing are owned by Endeavour. In fact, the only reason I know they are private label is due to the fact I have been checking the back of packaging regularly every time a friend brings some drinks over. This “phantom” private label approach is why I believe consumers and analysts alike are mostly oblivious to the change occurring.
In the last year, it is currently June 2021, Pinnacle have introduced over 200 separate products to Endeavour’s shelves. In a good year CUB, TWE or Accolade would be lucky to introduce a handful.
Of the three times I’ve checked a friend’s drinks they have been Pinnacle brands. On each occasion I have questioned the individual why they bought the particular product, the response every time was “because it was on special and seemed nice”.
Hence, I am convinced that the average shopper cannot tell private label from branded products unless they check the back of the package. The online reviews also indicate that consumers are enjoying the products as well.
How Pinnacle Helps Endeavour Serve its Purpose of Existence
Dan Murphy’s is Australia’s cheapest place to buy a wide range of liquor, and in short that is the reason why it exists. Cheap liquor and a wide range are what sets it apart, attracts customers and keeps them coming back. The cheaper the liquor and the wider the range, the stronger the offering.
So, whilst the savings could be used to increase gross margins, they won’t. Instead, management will pass savings on to customers to further lower prices and increase market share whilst maintaining a wide range of product offerings.
We can tell this because it’s what they have done historically. Extensive discussions with industry insiders who deal directly with Endeavour indicate that their wholesale prices have reduced significantly over recent years due to pressure from Endeavour channel managers. Below is Endeavour's gross margin data for the previous 5 years:
Evident in the above is that these savings have not shown up in gross margins, which as you can see have been static at 23% for the previous 5 years. What this means is Endeavour is passing on their savings through to the consumer, driving more sales and increasing sales per square meter:
How Much Margin Can Be Eliminated?
Having now looked at the demand side of the private label equation it is now important to look at the benefits from the supply side to see just how much cheaper private label can be. To do this I have looked at listed liquor producers and where their margin is being spent.
The easiest way to do this would be to first remove marketing expenses, as brand recognition is not the area Pinnacle brands will seek to compete, but on price for reasons previously outlined.
If we look at Diageo, arguably the owner of the world’s most recognisable liquor brands their marketing spending represents 15% of revenue.
Then looking at Treasury Wines we can see that about 20% of revenue is spent on SG&A, with the lion’s share going towards marketing. The story is similar when looking at other liquor producers.
There is a finite amount of margin that can be squeezed out of private label and it is likely limited to within the SG&A line.
Given the above SG&A margins it would be reasonable and fair to conclude that in the long run Endeavour should be able to produce private label products at least 25% cheaper than they can purchase equivalent offerings. These savings will then likely be passed on to the final ticket price in the form of discounts and promotional offers.
Industry Murmurs Are Not Promising for Liquor Producers
The heat is already being applied to branded product suppliers to reduce their prices to compete with Pinnacle private label products. Talking to industry insiders within the sales forces of liquor producers makes it apparent that their biggest competition is no longer amongst themselves but instead with Pinnacle for Endeavour’s shelf space.
Push back against wine suppliers started at the sub $10 per bottle range, with Endeavour channel managers asking something along the lines of “tell me why I should buy anything that will retail for under $10 when we can do it ourselves?” This discussion subsequently moved to sub $15, with Endeavour as of 2021 now pushing back against any sub $20 product with their own Pinnacle substitutes.
Why Can’t Competitors Also Go Private Label?
The short answer is that they will, but it won’t be as potent. With 40% of retail liquor sales Endeavour can support a much wider range of private label products, strengthening their offering further.
Coles, with 14% market share, are producing private label wines under their own Exclusive Liquor Brands (ELB) strategy, with private label penetration at 20% of their sales. However Coles faces the following headwinds when competing on price against Endeavour who:
Currently lead on low prices
Have twice the breadth in distribution, justifying a wider private label range
Can exert more pressure on suppliers for exclusivity given their distribution advantage
Will be a standalone and independent business with a management team dedicated to gaining market share
Given these factors it is unlikely Coles can ever lead in low prices or defend its market share in the face of what appears a more superior private label business in Pinnacle Drinks under an independent Endeavour Group.
An Independent Endeavour Pushing Pinnacle’s Drinks
Private label retail liquor is not a new phenomenon, with Pinnacle being set up in 2012 to finesse the private label strategy. However, the pace and effectiveness at which private label is being introduced to shelves has increased tremendously over the past year.
I do not know exactly what has motivated this change. So far, I am of the belief that it is the product of an independent management team and existing branded suppliers being pushed to their lower limits on price.
An example of recent expansion and execution is within the craft beer market, the only growing segment of the declining beer market. Craft beer is a fragmented market characterised by low brand loyalty. Like wine, craft beer offers a fertile ground for the growing of private label liquor market share and Pinnacle is executing brilliantly.
Below is a collection of Pinnacle's craft beer brands that won design awards, including best design, at the Australian International Beer Awards:
Endeavour Groups Hotels Business
The demerged Endeavour Group will also include the ALH hotels business. This business consists of 332 licensed venues across Australia and 12,364 electronic gaming machines (EGMs) which are colloquially known in Australia as “pokies” and in the US as “slot machines”. Revenue from EGMs accounts for 7% of Endeavour’s total revenue. The EGMs are also the reason that the ALH business enjoys net margins that are almost triple that of the Endeavour Drinks business.
Endeavour is stuck with the hotels business as it is central to the Endeavour Drinks business’s presence in the state of Queensland. Queensland only allows the sale of retail liquor by holders of Commercial Hotel liquor licences (Liquor Act 1992).
These licenses cannot be granted to premises that are used primarily as a supermarket, which requires the ownership of pubs to be able to have a retail liquor presence. Commercial Hotel license holders can operate a liquor store attached to the venue as well as 3 detached bottles shops (DBS) within a 10km radius of the venue, for a total of 4 liquor stores. Exceptions to the 10km radius are made for more rural areas.
Given the regulatory landscape in Queensland, any spinoff of the hotels business would require the spinoff of the Queensland liquor retailing operation, which just isn’t going to happen. So, it appears Endeavour Group are stuck with the EGM business for as long as Queensland’s liquor regulation stays in its current form.
Digital Assets and a National Network for Liquor Delivery
The My Dan’s loyalty program was launched in 2015 and currently has 5.1 million members. BWS currently falls under the umbrella of the Everyday Rewards program, which currently has 12.8 million members. BWS’s participation in Everyday Rewards will continue for at least 5 years post-merger as set out within the demerger booklet.
The BWS and Everyday Rewards agreement is exclusive for the 5-year period mandating that “BWS does not offer loyalty benefits other than Everyday Rewards loyalty benefits”. This reduces the potential for any immediate expansion of the My Dan’s offering across the Dan Murphy’s and BWS store networks.
In 2018 Endeavour purchased the Uber-styled liquor delivery service, Jimmy Brings. The service has since been integrated with the BWS store network giving the Jimmy Brings service unmatched reach across Australia. Jimmy Brings is slowly expanding its coverage across Australia and currently operates in Sydney, Melbourne, Brisbane, Gold Coast, Canberra, Adelaide, Perth and the Sunshine Coast. The business has been transformed into a delivery service operating from BWS stores where a 15% margin is added to the BWS shelf price as well as a $6.50 delivery fee.
With a combined number of 1,962 licensed venues across BWS (1384), ALH (332) and Dan Murphy’s (246), Endeavour is well positioned to extend Jimmy Brings’ lead in same day liquor delivery. This lead will be hard for competitors to dislodge. This is due to network effects that Endeavor enjoys, which unlike food delivery, are supported by increasing state level regulatory requirements for the delivery of alcohol.
Endeavour is set for listing July 1st, code EDV:ASX. The standalone Endeavour Group has reported pro forma sales revenue of $10.6 billion, EBIT of $693 million and operating profit after tax of $328 million for FY2020. EBIT is depressed due to the impacts of Covid-19 on the higher margin hotels business. Capex is roughly around $350 million, which I expect to tick up. ROCE is stable and in the mid to high teens.
I have put together a three-statement operating model forecasting how these numbers should likely change over the next 5 years, which can be downloaded here. The model is a work in progress so don’t forget to check back as it will continue to be updated over time. A PDF version of this note is also available at the file location.
Consensus forecasts place the market cap between $11 billion to $15 billion for the group. Of interest is the fact that the group is the third largest poker machine owner in the country, setting up the possibility for severe downward price action as investment managers have to clear the stock from their portfolios upon demerger.
This sets up the possibility to pick up what is an excellent business for a steal if there is not sufficient liquidity to fill sell orders upon delisting in early July. Hence, I believe it is a stock worth keeping an eye on.