The pub is the cornerstone of British life. It offers comfort, an escape and is often associated with merriment. But Britain’s pub sector hasn’t always brought investors the same joy. The industry, which experienced vast and over-leveraged expansion in the freehold property market in the early 2000s, was forced to pay for its ambition when the credit crunch took hold in 2008. Debt soared, new openings ceased and derelict, closed-down former pubs became a regular eyesore up and down the country.
There can be little doubt examples such as Punch Taverns (PUB) damaged sentiment for the sector’s financial responsibility. A lengthy fight to refinance a major debt pile has tarnished the company, with the share price now dwindling at a mere 9p. Punch is worth less than £100m, and yet its debt pile exceeds £2bn. While the row over the debt continues, it’s trying to offload multiple properties to make sure future ends meet. At the time of the half-year results in April, it had disposed of another 140 pubs from its non-core estate – for £51m – but it still has 1,000 more to go. Chairman Stephen Billingham says reinvestment will continue in the remaining estate so when the debt is refinanced, the company can catch up with the competition. But frankly, even if the 16 tranches worth of debt across two securitisations (Punch A and Punch B) held by multiple creditors is re-arranged, it’s questionable how much cashflow Punch will generate for reinvestment to make a difference. After all, companies don’t go bust because of debt per se, but because the cashflow isn’t sufficient to pay it off. Indeed rival group Enterprise Inns (ETI) had close to £4bn in debts on its balance sheet at one time. Along similar lines, Mitchells & Butlers (MAB) is still struggling with a £250m pension deficit and an underperforming operating business.
But the heady days of the credit boom aren't the only reason why the pub industry in a mess. The smoking ban, changes in alcohol licensing laws and fewer Britons drinking beer have left many wet-led boozers facing a challenge, specifically with falling beer and brewing volumes. Nevertheless, as Britain slowly returns to growth some pub companies are regaining lost confidence. Across the retail and consumer industries, much has been done to understand the changing nature of the British customer and business models have had to adjust accordingly. In the pub sector this has meant concentrating more on food menus, offloading underperforming properties, and tailoring the remaining ones to the demographics they serve.
Marston’s (MARS) – a company we advised buying in May – has dedicated itself to these changing trends. Marston’s success in rejuvenating its estate since the credit crunch is attributed to chief executive Ralph Findlay’s “F-Plan” which prioritises families, females, forty-somethings and - most importantly - food. Pubs traditionally focused on drink sales because it was a higher-margin business, but Mr Findlay says Britain’s average consumer now looks for the most ‘bangs for their bucks’ and wants food to play an important part in weekly trips to the pub. Mr Findlay also points out many household spending decisions are made by females and describes them as a ‘prime customer target’. In our opinion, this has helped separate Marston’s from some of its competitors, and yet the shares have suffered a significant de-rating since annual results in May.
And Marston’s isn’t alone. Other pub companies such as Spirit Pub Company (SPRT) and Fuller, Smith & Turner (FSTA), which we also believe are higher-quality investments, are suffering similar share price declines despite little change in their fundamentals. The de-rating trend is puzzling. It’s even more curious when one considers the bullish outlook on the sector from City analysts just a few months ago. Simon French, a leisure analyst at Panmure Gordon, was quoted last April in the national press praising the pub companies for improving their balance sheets. Examples included Spirit – which was spun out of Punch in 2011 – and its success in renegotiating more flexible debt terms late in 2013.
Admittedly, some recovery plans have hit rocky patches, a prime example being Enterprise Inns. At the start of 2014, the shares had risen six-fold since the company avoided collapse in 2012. But since then, the share price has fallen from over 160p to 113p. The stumbling block, it would seem, is changing regulation. The Department of Business has confirmed the introduction of a statutory code for tenants and landlords, as well as the ‘free of tie’ option – which would stop pub groups from selling beer at a premium to market rates, in exchange for cheaper rent. Some analysts are clear-cut about the risk: a statutory code is not a problem but a free of tie would be ‘meltdown’ for the sector.
Other companies, like JD Wetherspoon (JDW), are still not happy with the taxation system pubs have to work within. Tim Martin, chairman and founder of Wetherspoon, has long-called for equal VAT duty on food sales for supermarkets and pubs. But he also points out that the law discriminates against pubs in less-affluent parts of the country. In July, it reiterated its concern over the coalition government's 'late night levy' which it says resulted in annual charges of up to about £4,000 per annum for pubs opening beyond midnight in the north of England. At some of its locations, Wetherspoon’s has reduced opening hours from 1am to midnight on Fridays and Saturdays which it says is a ‘retrograde step’, and one which will have ‘a positive impact on supermarkets’ as pub-regulars go in search of more booze beyond last call.
IC VIEW
It’s clear the pub industry has a way to go before it returns to full-health. But the serious concerns – waning consumer demand and unmanageable debts – look set to become woes of the past. Changing and punitive regulation now poses the biggest challenge, but investors should have faith in Britain’s quality pub businesses to take this on. Britain’s pub sector can offer investors value and future growth. Income-seekers are not always best suited to this sector, but as an industry in recovery it offers future upside to those investors with risk-hungry holes in their portfolios. It should be the view that weakness in a company’s share prices offers a good buying opportunity, and a chance to buy into the quality-businesses stocks at a discount before they re-rate. Investors want to look for companies which have successfully handled their legacy debt issues, are streamlining their estate and are pouring cash into new products and upgrading their existing properties.
Favourites
We rate Marston’s (MARS) and Spirit Pub Company (SPRT) as ‘buys’. Spirit shares offer great value, carrying an enterprise value (market capitalisation plus net debt) equivalent to 9.3 times cash porofits (plus rents), meaning the shares trade at a discount to the sector average of 10.9 times. This makes it the cheapest of all comparable sector peers. That said, Marston’s also offers an attractive – and rare for the sector - dividend yield close to 5 per cent, which investors could benefit from whilst waiting for growth initiatives to translate into future sales improvement. Similarly, Fuller, Smith & Turner (FSTA) and Young & Co’s Brewery (YNGA) have solid business models, capitalising on their London and South East niches. They’re pricier investments, but both are generating good sales and profit growth year-on-year, which could translate into better shareholder returns down the line.
Outsiders
The obvious outsider is Punch Taverns (PUB). While analysts believe the debt issues could be settled before the end of 2014, there are still structural issues within the operating model which are fundamentally broken. Even with successful refinancing, Punch will be severely constrained in its ability to reinvest in its properties and products.
