Is this really the end of Masters?

Race City USA will help decide if Masters retires from the hardware race or simply needed a pit stop.

About 25 miles north of Charlotte North Carolina lies the city of Mooresville, known to NASCAR enthusiasts as ‘Race City USA’ because many of the competition’s racing teams call it home.

But Mooresville has another famous resident, American home improvement company Lowe’s (NYSE:LOW). Lowe’s is the minority partner in Masters, the struggling home improvement chain majority owned by Woolworths (ASX:WOW).

In 2009, Lowe’s was given a put option that allowed it to sell its 33.3% stake in Masters to Woolworths at fair value. That put option can now be exercised. In its 2015 annual report, Woolworths carried the value of this option as an $886.5 million liability.

As the terms of the option is based on a free cashflow valuation assuming future performance, the actual value is unclear. It could, however, be a lot lower than its carried value if the business is wound up.

In such a case, the payment to Lowe’s will be less as it would recoup much of its investment through the sale of its valuable property network, potentially to its biggest competitor, Bunnings.

Lowe’s hasn’t said a word on whether it will stay the course or get out but in an August earnings call chairman Robert Niblock said he was ‘very impressed with the progress that I see the team making down there’.

Maybe Niblock was just trying to pat the natives on the head before moving on to something more important but one cannot discount the fact he may actually have meant it. That scenario – Woolworths wanting out but Lowe’s wanting to stay in – isn’t getting much coverage.

Estimates of Lowe’s support for Masters stretch to $1.1 billion. Assuming the total value carried on the Woolworths accounts is accurate, Lowe’s would lose around $220 million on its investment.

That’s wearable, especially compared to Woolworths, which is believed to have invested $2.2 billion. To buy Lowe’s stake in Masters would require another $800-$900 million.

Many commentators have suggested Woolworths should put Masters out of its misery, a view that carries some weight.

The supermarket operation generates the vast majority of Woolworths’ profits and has probably been impacted by the focus on Masters. At a time when Coles and Aldi are becoming more aggressive, this management distraction has an unquantifiable but likely hefty price.

What about the argument to persist with it? This angle has barely been explored in the media, which much prefers a story along the ‘bloody disaster’ narrative.

But there is reason to believe it isn’t all bad. Masters has been experimenting with a new store layout and range which has seen sales per store increase 30% compared with the old format. Masters has since started retro-fitting old stores to the new, more successful format.

Moreover, the average Masters store has only been operating for two years. Many retail businesses take far more than that to perfect their business model. Can anyone pass judgement on the success or failure of Masters with confidence given that fact?

If management were operating in isolation it may be more inclined to persist – short term pain for long term gain and all that. Trouble is, many shareholders have already made up their mind and new Woolworths chairman Gordon Cairns seems inclined to go along with them, potentially before the new CEO lands in their chair.

Shutting up shop would be well-received by investors and give them clear air to gain lost ground in their supermarkets.

The more interesting scenario would be if Niblock really does like what he sees and decides Lowe’s should stay put. Woolworths would then arguably need to stay as well, and deal with a shareholder base that wants a short term result.

To borrow a NASCAR expression, if Woolworths finds itself in that position it will hope Masters just needs a tyre change when everyone else seems to believe the engine has blown.

Staff members may own securities mentioned in this article.

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