ESG: STAKEHOLDER RISKS Spotlight on Woolworths Limited

Authored by Mark Barraclough Is Australia’s most valuable brand gambling with shareholder value?

The case for reform:

Woolworths’ current heavy investment in high loss poker machines is potentially risky business due to the high social cost of the industry, particularly as it relates to problem gambling. The implications of a large and growing investment in electronic gaming machines that cause significant social harm could range from political or community obstacles to brand contamination of not only the Woolworths brand but also related potentially more vulnerable brands such as Dan Murphy’s, BWS and Thomas Dux. To date, self-regulation by WOW appears to have failed to the extent that it is not transparent or demonstrably effective. The reforms called for by the Productivity Commission, independent experts, multiple politicians, advocacy groups such as GetUp and individual customers and shareholders go beyond where WOW is currently willing to go. This is why GetUp members who are also WOW shareholders have called for engagement, disclosure and reform by calling for an Extraordinary General Meeting of WOW. These calls for reform have been public, sustained and of significant national profile and pose a legitimate threat to business as usual by management and the board. To date, WOW has not disputed shareholder claims that problem gamblers’ contributions to gaming revenues are estimated at least 40% of total gaming revenues, a statistic that highlights how a good deal more needs to be done to reduce the harm being caused by high velocity poker machines. GetUp questions whether the lack of transparency, oversight and engagement on such an important issue of social justice is indicative of wider issues within WOW’s strategic capability to prioritise and execute decisions based on its shareholders’ interests. In an effort to chase further profits to maintain shareholder value, Woolworths through its investment in ALH is diving even deeper into the poker machine business without addressing the risks these operations pose to its core operations. This report will show that Woolworths has a significant stake in the gambling industry –earning a conservative estimate of approximately $92 million in EBIT from its poker machine interests in FY11. An August 2nd, 2012 report by Citi Group put that number at $139 million. There are many instances of companies embracing pro-social reforms especially when those reforms are backed by membership or stakeholder alliances with vocal and impactful industry, political and community groups with a longstanding commitment to change. Embracing responsible social reform can lead to the passage of legislative reform that would serve a greater good and apply to competitors, especially if the EGM reaches a national profile where it could act as a catalyst for even further public support for reform. The below report was commissioned by GetUp and written by independent ESG analyst Mark Barraclough, formerly of MSCI and RiskMetrics. The report lays out the growing stakeholder risks incurred by WOW’s ongoing gambling interests specifically as they relate to electronic gaming machines.

Scope of Report:

• Growing Stakeholder Risk Over Gambling Interests: With pro poker machine reform organisations frustrated by the Gillard Government’s watering down of poker machine reform legislation, social activist organisations such as Getup have turned attention to the largest operator of poker machines in Australia, Woolworths Limited (Woolworths). • This report examines Woolworths’ risk exposure over its involvement in the poker machine business and explores the potential risks to shareholder value should this issue continue to gather momentum.

Recent Developments:

Engagement Becomes Adversarial On the 25th June 2012 Woolworths’ shareholders and Getup members submitted requests to hold an Extraordinary General Meeting (EGM) to vote on motions seeking to amend the company's constitution to prevent it from owning or operating poker machines with more than a $1 maximum bet from 2016. The resolution would also impose a revenue limit of $120 per hour and restrict the use of gaming machines to no more than 18 hours a day from 2016. On 3rd July 2012 Woolworths took the matter to the Federal Court requesting that the motions be rolled into its AGM in November. While the Federal Court decided to defer the resolutions until November, Woolworths withdrew its request to call off the EGM. Meanwhile, GetUp filed complaints with the Australian Stock Exchange and the Australian Securities and Investments Commission arguing that Woolworths has yet to notify shareholders of the request for an EGM. With engagement between Woolworths and Getup becoming increasingly adversarial, there is potential for this stakeholder issue to expand to more public forms of agitation ahead of the EGM and beyond. With over 600 000 members across Australia and with over 80 000 of its members already signing a petition supporting the campaign, Getup is well positioned to pursue its agenda. Under these circumstances, the question is how much could this issue potentially damage the Woolworths brand, and conversely, could adopting the suggested reforms be financially justified purely from a strategic risk management perspective?

Can Woolworths Carry The Public Debate Over $1 betting limits?

If one aligns the arguments for and against the suggested reforms the conclusion is no. Social activist groups pushing for reform make a cogent case for why lower betting limits are warranted and their arguments are in line with the Productivity Commission Inquiry into Gambling 2010 recommendations. The introduction of $1 betting limits is also well supported by a broad coalition of Church groups and social welfare organisations. The logic behind the proposal to introduce lower betting limits is simple to understand. Currently many ‘high velocity’ poker machines allow gamblers to lose up to $1200 an hour. Lowering the betting limit from $10 per spin (or $5 in Victoria) to $1 per button press will dramatically slow the process whereby problem gamblers can lose substantial sums of money and get into a position where they are chasing their losses. Once limited in this way poker machines will also not be able to take more than $120 in any given hour. The Productivity Commission Inquiry into Gambling proposed both the introduction of $1 betting limits and a trial of mandatory pre-commitment technology as a means to minimising the harm caused by high velocity poker machines. From the Productivity Commission Draft Report 2010 Chapter 11: “There is a strong case on net social benefit grounds for a much lower bet limit: a limit of around $1 (which would still be equivalent to an average $120 per hour of play if the gambler plays quickly) would reduce harm from high intensity gambling without unduly affecting recreational gamblers (who typically bet at quite low levels).” By comparison, Woolworths appears to acknowledge that there is a “serious problem” which needs to be addressed and yet its majority owned ALH Group opposes lower betting limits. At its annual general meeting in 2011 the Woolworths chairman, James Strong stated : “We do not deny that there is a serious problem about people who have gambling problems “. The company also states in public releases that “Woolworths absolutely supports proven reforms that will genuinely help problem gamblers without preventing responsible players enjoying a flutter.” In its submission responding to the Productivity Commission draft report, the ALH Group stated that its preferred outcome would be to see further voluntary pre-commitment trials rolled out and Woolworths has stated it also supports this initiative. However, ALH Group is already trialling voluntary card based pre-commitment at one of its hotels in Queensland and reportedly only 11 % of patrons have taken part in the trial. Voluntary pre-commitment has been widely criticised as ineffective because problem gamblers are unlikely to participate, or if they do, there are a number of ways they can step around the technology when it suits them. Regarding the $ 1 betting limit recommendation, the ALH Group made the following comment in its response submission to the Productivity Commission draft report: “Even if such policy measures could be demonstrated to have some level of impact on reducing the level of problem gambling, the benefit would be unlikely to be outweighed by the substantial detriment to recreational players and the industry overall - thus imposing a social net cost.” ALH Group supplied no supporting evidence illustrating what the ‘substantial detriment’ would be to recreational players, however it did state that such an initiative could see a drop in gaming revenue of 40% . Another point Woolworths is making is to emphasise that the company controls only 6% of the nation’s poker machines. However, as the largest operator of poker machines in Australia it is difficult to see many people agreeing that it is unreasonable to single Woolworths out over the issue of poker machine reform. The fact is a majority of the Australian population support measures to reduce the harm being caused by high velocity poker machines and this means most people will be sympathetic to the campaign being run by activist groups and disinclined to accept the arguments being made by a large corporation who profits from the poker machine industry. A poll conducted by the Australian National University in 2011 showed 74% of Australians support further initiatives to reduce the harm caused by poker machines. Under these circumstances it is difficult to see Woolworths being able to maintain its current position and not sustain damage to its brand as activist campaigners work to educate the general public about their involvement in the poker machine business. *Australian National University Poll July 2011

The Scope of the Problem.

The Productivity Commission Inquiry into Gambling report of 2010 found* among other things that: Australians spent more than $19 billion on gambling in 2008-09 and around $12 billion of this sum was spent playing poker machines. Social costs stemming from problem gambling are estimated at $4.7 billion a year. 600,000 Australians play poker machines on a weekly basis and 15 per cent of these regular gamblers are problem gamblers and account for 40 per cent of expenditure on the pokies. One in six people who play the poker machines regularly have a severe gambling problem. Three-quarters of problem gamblers have problems with poker machines. The number is higher for women – in 9 out of 10 cases poker machines are identified as the cause of problems for women. Some poker machines can be played at extremely high intensity where a gambler can lose $1,200 per hour. People who have a problem with gambling lose an average of $21,000 a year. Problem gamblers and their families have a significantly lower quality of life and may suffer mental and physical health problems, find it difficult to hold down a job, and struggle to maintain relationships. (*Productivity Commission 2010, Gambling, Report no. 50, Canberra; and Productivity Commission 1999, Australia’s Gambling Industries, Report no. 10, AusInfo, Canberra)

What is the poker machine business worth to Woolworths?

Through its controlling 75% interest in Australian Leisure and Hospitality Group ( ALH Group), Woolworths declared revenues from its Hotels segment of $1.153 billion in FY11 and earnings before interest and taxation (EBIT) of $184 million. In its 2010-11 annual report the company did not disclose the percentage of revenue, or EBIT figures, flowing directly from ALH Group poker machines, however, it did state that ‘gaming’ comparable sales were up 3.1% yoy in Victoria. Australian Bureau of Statistic figures indicate that gaming revenue in hotels equipped with gaming machines is in the order of 28 % of gross revenue. Therefore it can be estimated that Woolworths received revenue of conservatively $322 million from its 12000 plus poker machines in FY11. In the absence of company disclosure, poker machines are estimated to contribute 50% of hotel EBIT which means Woolworths earned approximately $92 million in EBIT from its poker machine interests in FY11.* With Woolworths group EBIT in 2010-11 of $3276.4 million poker machine EBIT represents some 2.8% of group EBIT.

Woolworths FY 2011 Revenue

Group Revenue $54.1 b

Hotel Segment Revenue $1.15b

Woolworths FY 2011 EBIT

Group EBIT $3.2 b Hotel Segment EBIT $185m

Woolworths FY 2011

Group EBIT $3.2b

Est Poker machine EBIT $92m

* This is an estimate which takes into consideration the lower input costs associated with poker machines when compared to other hotel revenue streams related to the sale of food, beverages and accommodation. Poker machine profits could be higher than 50% of the hotels segment EBIT and we encourage Woolworths’ investors to seek clarification from the company.

Cost of adopting EGM reforms

Key Points

No material impact until 2016. As the suggested changes would not take effect until 2016 ALH Group would be able to begin introducing new poker machines with $1 betting limits incorporated into their software code when existing machines are turned over.

From the Productivity Commission Inquiry report:

“Industry participants noted that, where harm minimisation policies require upgrades to gaming machine software, the compliance cost for industry is much reduced (in some cases, almost completely negated) if the upgrades follow the normal replacement cycle for EGMs.”

ALH Group is believed to upgrade software on the majority of its poker machines on a five year cycle which means the group has three years to phase in software upgrades before January 2016. This potentially leaves 40% of ALH Group’s 12,000 poker machines (4,800 machines) with two years to run before they would be due for an upgrade.

Depreciating these 4,800 machines 60% for the three years they are in service and using an initial value of $25,000 per machine, gives a theoretical depreciated value of $10,000 on 4800 machines. Thus total cost of a premature replacement would equate to a write off of approximately $48 million. However the reality is the operator could bring forward the software upgrade and not write off the remaining value of these poker machines. An Australia Institute report into the implementation cost concluded the likely cost of early upgrades would be only $4000 per machine giving a lower figure of $19.2 million.*

Adding to the implementation costs, there is potential for some poker machine consumers to take their business to another establishment with higher betting limits and clearly lower betting limits are likely to see a contraction in gaming revenue.

Allowing that a higher proportion of problem gamblers could take their spending elsewhere, and given that problem gamblers are believed to contribute up to 40% of gaming revenue, it is estimated that somewhere between 20% to 40% of poker machine revenue could be lost. This would equate to a spread of $64 million to $128 million p.a based on FY 11 estimated poker machine revenue for company’s hotel segment.

Offsetting this immediate impact, the company should be able to attract patrons who are alienated by the risks associated with high velocity machines. In other words, lower betting limits would make the company’s poker machines more accessible to a wider market and therefore any drop in revenue could arguably be expected to recover over time.

Furthermore, the company should be able to promote the introduction of $1 maximum bets. This would have many intangible benefits in terms of promoting the Woolworths brand and resolve the company’s exposure to the poker reform debate over the medium term. With regulators already lowering betting limits in Victoria to a maximum $5 bet, there is a risk that if Woolworths delays implementing further reforms it will miss the potential upside while allowing its reputation to be tarnished.

*The Australia Institute, Rubbery Figures (January 2012)

Potential Cost of resisting reforms

Should Woolworths reject the suggested reforms the company is likely to be exposed to a prolonged and concerted campaign. Unlike most other participants in the poker machine business Woolworths is uniquely exposed due to the nature of its core business. Woolworths is still predominantly a operator where a positive customer experience and strong brand image are paramount to supporting its leading position in a competitive marketplace. Woolworths devotes a significant sum to advertising its brand each year ($145 million in 2010) and toward presenting itself as a responsible and sustainable corporate citizen. To this end it is highly successful. The brand is regarded as Australia’s most valuable brand, valued at $7.6 billion according to Brand Finance. On the negative side, Woolworths already attracts criticism from many quarters over issues such as the concentration of ownership in grocery retailing, impacts on corner store grocery retailers and the use of its considerable purchasing power when negotiating with suppliers. These issues can and do have an influence on the Woolworths brand and customer perceptions. However, unlike the above issues which do not directly impact on most Australians, the social problems associated with high velocity poker machines are being felt across many communities. Curiously, the vast the majority of Australians do not yet realize that Woolworths is the largest operator of poker machines in the country. Thus this issue looms as a strategic risk to the company’s valued brand. Given the scope of existing community groups campaigning for poker machine reforms and with public opinion predisposed toward poker machine reforms, there are some general comparisons that can be made to other stakeholder campaigns. Examples include the Franklin Dam blockade, opposition to Gunns’ activities in Tasmania, James Hardie’s handling of asbestos liabilities and the proposed reopening of the Jabiluka uranium mine in Kakadu. While these examples involve environmental concerns and problem gambling is clearly a social issue, the intensity of debate on this issue in Australia over the last year suggests that many consumers could be willing to take up this cause. While it is not possible to predict precisely how this issue will evolve, it is common for activist groups to call for consumer boycotts and public rallies when other forms of engagement fail. It would not take a large shift in consumer sentiment to have an impact on Woolworths’ supermarket segment cashflows. The methodology of activist groups follows a well trodden path which uses a variety of strategies to draw the reluctant protagonist into a public debate where it is vulnerable to accusations of putting profit before social responsibility. The proposed EGM is a case in point. Irrespective of whether these resolutions are voted down, the motion will have achieved the aim of bringing Woolworths into the spotlight over this issue and its integrity as a socially responsible corporation will be questioned. The cost to Woolworths could be significant if this issue evolves into one involving street protests similar to those we saw against the ANZ bank over its involvement in financing the proposed Gunns Pulp Mill. Damage to the Woolworths brand could conceivably outstrip the estimated costs outlined in relation to introducing $1 betting limits. Once the momentum is behind a stakeholder campaign, it is increasingly difficult for any company to get its message across to win back support. A belated retreat is not nearly as strategic given it can be portrayed as an admission of guilt. In this way corporations can find themselves in a corner as their options become more limited. At some point the investment community may begin to see the financial repercussions and choose to sell shareholdings. Once the market loses confidence in a company’s ability to navigate a way out and maintain its social license, the deterioration in shareholder value can be severe.

Conclusion

As illustrated in this report, Woolworths’ involvement in poker machine gambling is a potential strategic business risk to the organisation. With an increasing stake in an industry that is receiving growing public scrutiny and criticism, WOW's brand is also likely to be more exposed due to an apparent inconsistency between the public facing family-friendly brand and the lack of a publicly available and demonstrative harm minimisation strategy regarding WOW's gambling investments. For these reasons it is likely that poker machine reform campaigns will continue to gain traction in the media and it can reasonably be expected that this stakeholder issue will continue to gather momentum until the issue is addressed in a meaningful and demonstrated way.

Authored by by Mark Barraclough