Last November, Britain's largest pub companies were dealt a serious blow after MPs rebelled against the government and voted to add a Market Rent Option (MRO)* to the Small Business, Enterprise and Employment bill. Companies such as Enterprise Inns (ETI) and debt-laden Punch Taverns (PUB) recorded double-digit share price falls, while recent acquisition-target (and Punch Taverns spin-out) Spirit Pub Co (SPRT) was down 6.5 per cent on the day.
Voting through the MRO would remove the 'beer tie' that critics claim is essentially uncompetitive and works unfairly in favour of parent pub chains. Under existing laws, tenants are obliged to purchase supplies exclusively from the pub owner. Removing the 'tie' would allow pub landlords to purchase goods from wherever they choose, thereby driving up competition in the market by removing the effective monopoly held by listed pub companies.
Since last year's vote, City analysts have tried to make sense of the new legislation and what it could mean for pub companies traded on the London Stock Exchange. At the moment, companies like Enterprise Inns derive a substantial amount of their income through tied beer purchasing, also known as 'wet rent'. The compulsion to sell beer made by the parent company would not apply under the new rules and analysts at Numis said the elimination of the beer tie would damage pub companies' profitability. Not only that, but a number of pub companies with large tenanted estates are refurbishing and upgrading their pub portfolios. It's conceivable that this would come to an abrupt end with the introduction of an MRO, as it would cut off a significant source of cash flow.
Last year, government research claimed the introduction of an MRO would lead to 1,400 pub closures in Britain because it would reduce pub buying power, capital investment and tenant support. Numis has pointed out that Enterprise Inns and Punch Taverns together allocate £170m a year in upkeep and improvements on their 9,200 pubs. Proponents of the existing system argue that the overall level of investment, which is six to seven times higher than in the free-of-tie sector, is financed by the central purchasing power that the beer tie guarantees.
How the PubCo's compare
Even more surprising, the tied model has been reviewed 25 times since 1966 and has been found fit for purpose on every occasion. In 2011, the Office of Fair Trading (OFT) also weighed in, saying tied tenants are "no worse off" than free-of-tie tenants. Since then, as if to bear this out, tied rents have fallen, tied beer discounts have risen, tied support is up, and tied capital expenditure is higher.
Naturally, investors' reaction to the news hasn't been great. Last year, several pub companies saw their share prices click into reverse, as sentiment towards the sector turned negative. Shares in Enterprise Inns are down 30 per cent year on year, while Punch Taverns' - which spent most of last year wrestling with an enormous debt problem - faces an even bigger challenge to recaputure investor confidence.
Inevitably, there will be winners and losers. Some companies, including quality plays such as Fuller, Smith & Turner (FSTA), which don't hold extensive tenanted estates, will fall below a market 'threshold' where the new legislation won't apply. The brewer's share price has performed strongly since the start of the year, reflecting a 4 per cent increase in like-for-like profits for its tenanted inns division, in addition to a 4 per cent rise in beer and cider volumes. Although Fuller, Smith & Turnover won't be affected by the abolition of the beer tie, it has still moved sales director and board member Richard Fuller into a new position specifically designed to lobby the government. Similarly, although Young & Co's Brewery (YNGA) isn't directly in the firing line due to the size of its estate, chief executive Stephen Goodyear still labelled the laws "unfortunate and unnecessary". It could be that Messrs Fuller and Goodyear are concerned that the legislation, if ultimately deemed successful, could be extended right across the sector.
And perhaps industry lobbying has already paid-off. Like beer from an unscrupulous landlord, the MRO legislation has been watered down. In early March, the British government said exemptions to the MRO option will exist for "genuine franchise agreements" and pub companies willing to make "significant investments" in properties run by tenants - suitably vague. Secondary legislation will allow for a waiver in these circumstances. Analysts at Numis now believe downside risk on a number of pub company stocks is "minimal" as an "increasing range of options" to mitigate the effect of the MRO come forward. Analysts also pointed to recovery play Marston's (MARS) where, over the last six years, 98.3 per cent of Marston's lessees have rejected the company's offer to go free-of-tie. The proposed amendments still have to be passed by the House of Commons, but Numis believes the developments are "positive" for pub companies with tenanted estates.
*When news of the MRO vote broke, there were concerns Greene King's (GNK) bid for Spirit Pub Co might break down. Days before the vote, Greene King offered 0.1322 of its own shares, along with 8p in cash (to cover proposed and special dividend payments) in a deal worth 115p a share. That represented a 52.2 per cent premium to Spirit's share price prior to news of talks. But in late January, Greene King revealed Spirit shareholders "overwhelmingly voted in favour" of the merger between the two companies. The exact timing of the deal's completion "remains uncertain" but Greene King bosses expect to sign it off by the end of the first half of 2015.
IC VIEW:
We agree that the latest amendments to the MRO are positive for the sector. But if the changes are rejected by MPs in the near term, then a number of stocks could react badly again. The tenanted sector is highly susceptible to legislative changes - and there is always the chance that the MRO change may herald a step-up in interventionist legislation. That said, the government's attempt to make the legislation nuanced and sensitive to individual companies means well-run, quality outfits such as Marston's will be able to sustain a personal relationship with its tenants and avoid any unnecessary drama.
Favourites
At the moment, Marston's share price is up 3 per cent since our long-standing buy advice (147p, 22 May 2014). It is four months since the pub landlord reported a resilient set of results, which marked the halfway point in a "transformational" strategy to bring its estate up to snuff. Chief executive Ralph Findlay said the ongoing transfer of the estate into either managed ownership or a franchise system leaves the group with "barely any" exposure to the legislation. With the shares trading on an undemanding 12 times forward earnings, we're sticking to our guns on this one.
Outsiders
We're staying neutral on Enterprise Inns and Punch Taverns. The latter had a tumultuous year in 2014, including negotiations with bond holders on its debt-laden balance sheet. Enterprise has prioritised reinvestment in its estate as a core strategy, but analysts are right to suspect this could come under threat if tenants cut off a lucrative part of the group's revenues under the MRO rules. Shareholders could conceivably do well if Enterprise Inns decides to follow a real-estate investment trust (Reit) model, but until that becomes clear, we're giving both companies a wide berth.
