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Last orders?

Created:

3 July 2007

Updated:

4 July 2007

Written by:

Nathalie Olof-Ors

The pub sector, which has risen constantly since 2003, has taken a serious blow over the past month, dropping 8.4 per cent. Although the stock market has been generally weak this period, the FTSE All-Share index is down only 1.8 per cent, so pub shares have clearly underperformed. The worst hit has been Marston's, whose shares have fallen 17.5 per cent, followed by Young's, down 14.7 per cent, and Greene King and JD Wetherspoon, down by 12.5 and 11.5 per cent, respectively. Fuller Smith & Turner was the only share in the sector that managed to deliver a positive performance, though that was a mere 1.3 per cent gain. There are a number of reasons behind the sell-off: fears of a tougher trading environment, interest rate hikes, waning hopes that pub groups will convert to real-estate investment trust (REIT) status. Now, the English smoking ban, which came into force this week, has introduced another element of risk.

So, have last orders been called for the pub sector? The City is split on that front. For some investors, this adverse momentum suggests that it's time to cash in profits before they go up in smoke. Mark Brumby, analyst at Blue Oar Securities, points out there are substantial gains to protect, so "if investors are going to take profits, they would do better doing so before it becomes too fashionable."

Others, however, consider that the debate on the smoking ban is just a minor blip, which provides an opportunity to buy on share price weakness. Among those, Luke Newman, who manages the F&C Special Situations fund, argues that "the smoking ban has been well anticipated, so publicans were better prepared than in Ireland, where the legislation came into force shortly after being adopted. As a result, the impact was far less drastic in Scotland and the sale decrease should be short-lived in England."

Both sides seem to have a point. On the downside, the sector faces tough comparatives. Last year, the exceptionally warm weather helped publicans to reap the full benefit of the football World Cup, boosting their sales after a poor year in 2005 following the July terrorist attacks. So, the absence of major sporting events, combined with poor summer weather and terrorist car bomb scares, is bad omen. And now that the pavement has become the last refuge for smokers, the competition from supermarket booze, which has intensified during the past few years, might erode pubs' market share. So prospects for earnings upgrades look relatively slim. Higher interest rates provide a further headwind as the balance sheets of pub operators are heavily geared.

On the upside, though, pubs will probably remain England's social hub and the sector is one of the most resilient when disposable income shrinks. What's more, consolidation is far from over, so takeover bids could support share prices. As for interest rates, the largest pub operators have contracted debt at fixed rates, and so appear well protected against recent rises.

Conflicting arguments are also apparent in pubs' food strategy. To offset the decline of drinks sales, pub operators have enhanced their meal offerings in an effort to attract new customers who would like to enjoy a pub meal without coming home smelling like an ashtray. And as Horizons, the food-service research agency points out, there are growth opportunities, too - pubs are taking an increasing share of the UK breakfast market, for example. The bulls reckon that this new focus will only accelerate the trend observed in the past few years; beer sales have gradually declined, while the contribution of food to revenues has steadily increased.

But the bears point out that pubs are therefore moving into a largely oversupplied dining segment, all at the same time - so competition is likely to put pressure on margins. What's more, this move comes at a time when consumer confidence is declining. "Food sales have always been less recession-resistant than wet sales," Mark Brumby points out. "This is unlikely to change going forward. A couple of pints after work is less of a decision than is whether to have a meal, even at a casual dining outlet, with the entire family."

Only time will tell if the bulls or bears are right on this one. One thing, however, that all analysts agree on, is that pub shares are set for a rougher time until investors can put proper figures on the impact of the smoking ban.

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