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Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Shani Jayamanne: So Mark.

LaMonica: So Shani.

Jayamanne: So we sometimes have ads as part of the podcast, but it seems that we've been very, very good advertisers of The Gidley burger. We should have some sort of affiliate cash coming in.

LaMonica: Yeah, or free burgers. We do talk about it a lot.

Jayamanne: We do. So we know this because we have a listener who has emailed in and he wants to come and meet you for a burger.

LaMonica: Yeah, apparently.

Jayamanne: That's exciting. Do you think it'll live up to the hype?

LaMonica: Well, now I'm nervous, but I like it. So that's the important thing.

Jayamanne: I think we've hyped it up, but I think it's worth the hype. So…

LaMonica: I totally agree.

Jayamanne: We'll see what happens.

LaMonica: Yeah, but I don't know. I guess it's exciting. People don't normally want to go to meals with me. So I'll take what I can get.

Jayamanne: Well, there you go. But today we're going to do a share deep dive. We haven't done one of those in a while.

LaMonica: No. So why don't we get started?

Jayamanne: Okay. Well, we're doing a share deep dive, but we're doing it in a bit of a different way. And that is because we didn't start with a stock that was requested by a listener or has been in the news a lot.

LaMonica: We started with using our Investment Screener on Morningstar Investor. And what we searched for is all the popular factors that investors look for in a stock.

Jayamanne: We searched for a stock with a wide moat. That means that it's a business that can protect and grow its earnings over at least a period of 20 years.

LaMonica: We searched for a stock with an exemplary capital allocation rating. We also searched for a stock that has low uncertainty. And we're going to explain all these terms, by the way. So even though our analysts, of course, can't be 100% sure what is going to happen in the future for a company, they have confidence that they have a good handle on this share we're talking about today.

Jayamanne: We searched for a stock that was undervalued. It's currently a four-star stock. And we searched for a stock that is fully franked.

LaMonica: Yeah. And that does sound, I think, as you said before, that does sound like a lot of stuff that people are looking for.

Jayamanne: It does, Mark. And what do you know? There was only one stock that showed up in Australia.

LaMonica: Which is convenient because then we could do this episode. And once again, this would be a time where maybe a drum roll would be good. But that stock is Endeavour. So why don't we talk a little bit about what this company is and maybe a little bit of history about the business.

Jayamanne: Sounds good, Mark. So Endeavour is an omni-channel liquor retailer. And it operates the largest network of brick and mortar stores throughout the country. They've got more than 1,600 liquor outlets across the well-known Dan Murphy's and BWS brands.

LaMonica: And, Shani, what does BWS stand for?

Jayamanne: I don't know.

LaMonica: Beer Wine Spirits.

Jayamanne: Oh, well, there you go.

LaMonica: It's like a classic Australian name.

Jayamanne: Okay.

LaMonica: I mean, I'm an Australian now, but I don't know if you guys name things very well. It's all kind of obvious.

Jayamanne: Okay, sure.

LaMonica: It's like Opera House, Western Australia, South Australia, Northern Territory.

Jayamanne: We're simple people, Mark.

LaMonica: Great Sandy Desert.

Jayamanne: It's great and sandy, so.

LaMonica: Well, exactly. No, I'm just saying there's obvious names. All right. So you don't know what BWS stands for, but Dan Murphy's, have you heard of that? Just, you know, the local (bottler) in your neighborhood, right?

Jayamanne: Yes. Well, weirdly enough, Mark, it's basically the only place I can buy a liquor from. So I live in a dry zone, and for some reason, Dan Murphy's is the only mainstream liquor company that'll deliver alcohol to me.

LaMonica: Yeah. Ethically, I'm not sure how that works, but yeah, as a shareholder, I think you're happy that they've captured this market.

Jayamanne: Yeah, that's right, Mark. So Endeavour has also got substantial interests in hotels and electronic gaming machines, operating more than 12,000 gaming machines across its portfolio of more than 300 hotels, pubs and clubs. They're also one of Australia's leading employers with staff of more than 28,000 throughout Australia.

LaMonica: And the business is divided into two parts. So it has its retail segment in Australia, and as Shani said, it's Australia's omni-channel or multi-channel retailer, but it also has its hotel segment that provide hospitality services and, of course, everyone's favorite, gambling. So the retail segment is vertically integrated. So that means that the company controls the supply chain, and it's supported by something called Pinnacle Drinks, which is a private label portfolio of alcohol. They operate several wineries as well as bottling and packaging facilities. And the products from this process are supplied exclusively to Dan Murphy's, BWS and ALH group in Australia. And what the company gets from this is they get a higher margin. And margins are notoriously tight in retail businesses. So this is a very good thing. And they're also able to, of course, have a large amount of control in the wine supply chain, which minimizes their risk.

Jayamanne: And just like I mentioned that I ordered online, there's a few people moving to do the same. There's been a shift towards online shopping and convenience, so the business has invested in that. They've specifically done this with the online shopping platform and delivery capabilities through smartphone apps for each brand and online retailers like Jimmy Brings and Shorty's Liquor. This makes up about 9% of Endeavour's liquor sales.

LaMonica: And we did talk about these two different segments, but Endeavour's revenue is highly skewed to the retail segment. And our analysts, Johannes, forecasts that will contribute approximately 85% of revenue over the next decade. And then, of course, the rest comes from the hotel segment.

Jayamanne: And Johannes also expects consumer demand for alcohol to be relatively steady through the economic cycle, exhibiting attributes of consumer defensives. Things go well and people drink. Things go poorly and people drink. That's the definition of a consumer defensive company where sales don't change that much based on the economic cycle. We estimate the Australian hotels market will be driven by the same factors as the retail stores. And that's really down to population growth and inflation.

LaMonica: All right. So, with that little analysis out of the way. Why don't we move into all those boxes we're talking about that Endeavour ticks? So let's start with moat, Shani.

Jayamanne: All right. So as we mentioned, our analysts believe the stocks with wide moats can maintain a sustainable competitive advantage for at least the next 20 years. Endeavour Group has a wide economic moat in its core liquor retailing segment based on scale-based cost advantage. Firms with scale-based cost advantage can undercut competitors on price while earning similar or higher margins or they can charge market-level prices while earning relatively higher margins.

LaMonica: And then if we turn our attention to the hotel's business, that benefits from intangible assets. And as a reminder, intangible assets are assets that aren't on the balance sheet that you can't see or touch. And this can be a brand name or restrictive licenses like it is for Endeavour. So the hotel segment holds more than 12,000 electronic gaming machine entitlements as well as liquor licenses. So gaming licenses are capped at a state and territory level, which ultimately means there's a limit on the number of hotels, pubs and clubs that have the right to operate electronic gaming machines in conjunction with their hospitality services.

Jayamanne: And state caps are rarely altered with approximately 200,000 machines operating in Australia since 2001, according to the Queensland Treasury, limiting the supply of slot machines against a growing population. And what this led to is legislated and maintainable source of differentiation for the hotel segment and a barrier to entry for competitors. Endeavour's licenses are predominantly indefinite in length and they've also been growing the amount of licenses that they hold by acquiring competing venues.

LaMonica: And Johannes estimates that the total addressable market for Australian off-premises liquor retailing at $20 billion, most of that spent by Shani, in fiscal 2020. And he estimates that Endeavour's retail segment controls 47% of the market through the aforementioned BWS and Dan Murphy's brands, which collectively have approximately 1,600 outlets throughout Australia. And this is significantly larger than Endeavour's closest integrated retail competitor, and that's Coles Group.

Jayamanne: Who won't deliver me liquor?

LaMonica: Okay. Well, there you go. Well, sorry about that. But Coles Group, probably because they don't deliver you liquor, only controls 17% of the market and then there is Metcash's independent stores, which collectively hold 26%.

Jayamanne: Endeavour's dominant scale allows it to fractionalize distribution, administration, and marketing costs in a way that smaller competitors can't. That just means that the set costs can be distributed across a larger set of retail stores. So stemming from its dominant market position and significant scale advantages, our analysts estimate Endeavour to have a material, maintainable operating margin advantage over all its competitors.

LaMonica: All right. So we're off to a good start, Shani. That is the first tick we are talking about, the moat box. We then can move on to capital allocation. And our analysts, as we mentioned before, believe that Endeavour, their capital allocation, is exemplary. And leadership is ultimately, and we've talked about this before, Shani, but it's ultimately an exercise in decision-making. And of course, running a company is no different. CEOs make thousands of decisions over the course of their careers. Some are trivial and some can make or break the future of a company. And when we speak about capital allocation, it refers to the way that management and a business spend their capital, and it's particularly important in the current environment. And basically, it just comes down to three different places that capital can be deployed and they can make decisions about this. The balance sheet, investing in the business, so internally and externally, by buying someone else, and shareholder distributions.

Jayamanne: The capital allocation decisions that are made are based on the best utilization of the capital to create value for shareholders as the owners of the company. And these decisions are never static. It'll vary based on the company, the industry, and the market conditions.

LaMonica: And as we mentioned, of course, Endeavour has an exemplary capital allocation rating, and that is the highest rating that Morningstar awards. We think the balance sheet is sound. Investments as a subsidiary of Woolies have been exceptional, and the distributions via dividends to shareholders have been appropriate.

Jayamanne: So with those three avenues to allocate capital, we can start with the balance sheet. Endeavour's balance sheet is relatively strong due to the well-entrenched ability to generate cash. This is supported by the wide moat that we spoke about in the retail liquor market and entitlements to operate over 12,000 electronic gaming machines.

LaMonica: And then there's the investment side of things. Endeavour's investments have historically been well-directed with the expansion of outlets across the Dan Murphy's and BWS chains. This has built market share and strengthened their moat on scale-based cost advantage. Endeavour has also invested in the online sales channel. They've done this well ahead of major competitors, recognizing the ongoing consumer shifts towards all the things that we love about online shopping, convenience, range, and of course, being able to see prices.

Jayamanne: And lastly, distributions. So Endeavour's membership of the Woolies group means that their distributions to shareholders shouldn't really be considered in isolation. Endeavour hasn't committed to a dividend payout ratio target, but we think this is okay. Endeavour has only newly acquired the ability to make decisions independently of Woolies. But when the dividend is issued, it is fully franked.

LaMonica: And that is another box that we've ticked, Shani. All right, so let's move on to risk. So Endeavour is awarded the lowest uncertainty rating by Morningstar analysts. The company is subject to take risks that are by and large pretty common to most retailers. But as an established consumer staple retailer, our analysts think that its cash flow volatility is much lower than for a discretionary retailer, where consumer spending varies based on economic conditions.

Jayamanne: As an alcohol and gambling company, Endeavour has to be aware of ESG risks. Johannes states that the
risks associated with the off and on-premises retailing of alcohol products is predominantly managed by the substantial taxes on alcohol consumption in Australia. And that limits the potential for the abuse of liquor to a socially acceptable level.

LaMonica: Which is a great line. If you really think about it.

Jayamanne: Not sure about it, yeah.

LaMonica: Limit the abuse of alcohol to a socially acceptable level. There we go. And when we look over at the hotel segment, Endeavour is also it contributes a substantial amount of tax revenue. And that allows them to internalize the negative impacts of gambling abuse. They attempt to restrict gambling operations above those imposed by harm minimization legislation, such as through pre-commitment programs.

Jayamanne: But as we said at the end of the day, it's still an alcohol and gambling company. Analysts look at this purely from a risk perspective and not an impact perspective. So I think that's an important disclaimer to make.

LaMonica: That's right, Shani. All right. So let's talk about price. We all know that the key to successful investing is to acquire a quality investment at a reasonable price. And currently, as we record this, Endeavour is a four-star stock, which makes it undervalued. So on March 12th, it traded at $5.25. And the fair value that we assigned to Endeavour is $6.10.

Jayamanne: And that puts it at a 13% discount. And that sounds a lot lower than with other share deep dives that we do. When we talk about star ratings on stocks, it isn't just taking the discount or premium to fair value and it receiving a rating from 1 to 5. The uncertainty rating means that our star ratings are risk-adjusted and implement an appropriate margin of safety. So for a stock with a low uncertainty rating like Endeavour, to become a five-star stock, it requires a 20% discount. For a stock with an extreme uncertainty rating, it requires a 75% discount to become a five-star stock. And that makes sense. The less predictable the future outcomes, the higher the margin of safety we should demand as investors.

LaMonica: That's right, Shani. So on a risk-adjusted basis, Endeavour is still considered an attractive buy. It also ticks that box. But more importantly, we need to recognize that the boxes that this stock ticks are just based on research metrics that don't take anything to account from the investor's side. These reports, of course, and our analysts have no idea about your circumstances, needs or situations.

Jayamanne: And there's still some work to do after reading an analyst report to understand whether an investment is right for you and whether it aligns with your investment policy statement or IPS of your portfolio. A great resource to understand how this process might work is the episode that we did on Mark's Top 10 Holdings.

LaMonica: That's right, Shani. We started this process by going to the Investment Screener and putting in all the metrics that would make a stock attractive from a research standpoint. You can conduct the same exercise and look for stock that ticks the boxes that you need. For example, the stock may not be right for investors that are looking for a reliable income stream because Endeavour has not committed to a dividend policy or a payout ratio yet. If you are an income investor it doesn't matter whether it's ticked all the boxes from our analysts, still may not be right for you.

Jayamanne: So we encourage you to find these stocks. Many quality investments do not dip into undervalued territory or they rarely trade at a price that is considered a bargain. So a good idea is to find these stocks that do meet your criteria that can be added to a watch list. When there are buying opportunities, you can take it.

LaMonica: All right. So we made it, Shani. I don't know about you, but I kind of feel like a drink and spending some time with the pokie machine now.

Jayamanne: Do you?

LaMonica: I do. I do all this talk, you know.

Jayamanne: Do you think that your weekend has a potential for the abuse of liquor to a socially accepted level?

LaMonica: I think mine is the socially accepted part, absolutely.

Jayamanne: Okay.

LaMonica: Anyway, thank you guys very much for listening. Really appreciate it. And any questions, comments, or requests for burgers, please send it to my email address, which is in the show notes.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)