A rich Country Road offer, but not overdressed

Country Road’s update on its trading performance has been fortuitously timed to coincide with the bidder’s statement from South Africa’s Woolworths and to be tabled only a week before David Jones’ shareholders meet to vote on their $2.2 billion offer from Woolworths.

The underlying message to both sets of shareholders is similar: Country Road is performing so strongly that the $17 a share Woolworths is offering for the 12.12 per cent that it doesn’t already own – which includes the 11.8 per cent held by Solomon Lew – isn’t as over-the-top as it might have appeared.

Country Road said today that its earnings before interest and tax for the year to June were expected to be within a range of $92.9 million and $100.9 million. In the 2012-13 financial year the group had EBIT of $60.8 per cent. Total sales were expected to be 20.3 per cent higher than the previous year and comparable stores sales 8 per cent higher.

The strong performance of the group, while boosted because the previous year included only nine months’ contribution from its Witchery and Mimco brands, is potentially important in the context of the Woolworths bid for David Jones because it puts the $17 a share bid for Country Road into a slightly different perspective.

The bid looked way too generous, given that Country Road shares had traded below $5 at the start of the year, although the tiny free float in the market for the shares makes it difficult to read anything into its trading.

That apparent generosity, however, fuelled concern that Lew was going to receive a “collateral benefit” in Country Road – a benefit not available to other David Jones shareholders that couldn’t be justified on the basis of Country Road’s fundamentals – to induce him to support, or at least not vote against, the Woolworths scheme of arrangement that it is using to try to acquire David Jones.

Lew has a 9.9 per cent stake in David Jones and wouldn’t need to get his hands on too many more shares to be in a position to block the offer.

The Country Road bid, which is conditional on the success of the David Jones’ scheme, would deliver Lew more than $200 million, almost all of it profit, on a shareholding he has held since 1997. He would get out at least square, and perhaps with a very small profit, if he accepted the bid for his $200 million David Jones stake.

Woolworths is sensitive to the collateral benefits issue because the Australian Securities and Investments Commission argued before the Federal Court last week that the benefit should be independently valued so that David Jones shareholders were properly informed ahead of their vote. It also believed the synergies Woolworths might generate from owning 100 per cent of Country Road might have implications for the value of David Jones.

While Justice Kathleen Farrell ruled an independent valuation wasn’t required and that a letter of comfort from David Jones’ independent expert would suffice, ASIC hasn’t ruled out taking further action, including appearing before a court hearing scheduled to consider the outcome of the scheme meeting.

Justice Farrell – a former Herbert Smith Freehills partner and former president of the Takeovers Panel, and therefore a judge with a lot of commercial expertise – while saying the collateral benefit could be either $4 a share or $14 a share, also made the very commercial point of questioning whether David Jones shareholders would be willing to vote against their scheme on the basis of Lew receiving a collateral benefit.

The Woolworths’ bid for David Jones is considered very fully-priced and it is doubtful whether David Jones shareholders care whether or not Lew gets a special benefit in Country Road – as long as they get their $4 a share.

It should be said that contact between Woolworths and Lew’s advisers is said to have been minimal and that Woolworths doesn’t know what Lew plans to do in relation to either offer.

Lew is a vastly experienced sharemarket operator and is surrounded by experienced advisers and would know that there could be no understanding of any kind with Woolworths in relation to the shareholdings.

And so Lew has taken a punt on the prospect of the big payout in Country Road outweighing the temptation to block the bid for David Jones, keeping that group in play and bloodying the nose of the South African company, with which he has been at logger heads for nearly two decades.

The earnings guidance that Country Road issues today would suggest that at about 25 times this year’s earnings the offer is generous but defendable, given the trajectory of the group’s earnings.

If Woolworths does acquire David Jones, Country Road would be a major beneficiary of the South Africans’ plans to significantly lift the proportion of its own brands in the department store group, as well as continuing to benefit from the still quite immature rollout of its own brands in South Africa, where sales are up almost 20 per cent in the year to June.

Factor in all the positives and potential positives in Country Road’s performance and prospects and, while it still wouldn’t look cheap at an enterprise value to EBITDA (earnings before interest, tax depreciation and amortisation) ratio of 14.5 per cent, it wouldn’t be easy for ASIC to make the case that it was so outrageously generous that is was unequivocally and unacceptably a collateral benefit.