Calling time on Punch Taverns

Punch Taverns has busied itself this year with a financial fire-fight after the credit crunch started an inferno on its debt-doused balance sheet. The flames may not be completely out, but after reducing net debt by about £1bn over the last financial year, the blaze now looks under control. The share price has responded accordingly by more than quadrupling from its 12-month lows, but we believe there is a danger that, as the smoke clears, investors may not like what they see and the rally could shortly go into reverse.

First of all it's worth remembering that for all the progress, the group's borrowings remain very high. Analysts at Investec Securities forecast year-end net debt of £3.8bn, which is equivalent to nearly five times the group's market capitalisation. This suggests that debtholders are likely to play a far more pivotal role than shareholders in deciding the group's future for some time to come, and the recently-axed dividend is unlikely to be reinstated any time soon. What's more, while there is relative calm at the moment it is possible that further deterioration in trading will reignite fears about loan covenants.

Trading is undoubtedly proving particularly tough for pub owners that lease pubs to tenants. While Punch does manage some of its own pubs, around 84 per cent of its half-year cash profits came from ones that are leased out. The problem for tenants is that they lack the financial flexibility of large managed pub groups, and therefore are less able to compete through value-for-money deals. And in this sombre economic environment, value for money is what consumers want, as has been shown by the trading success of groups such as JD Wetherspoon, Mitchells & Butlers and Whitbread's pub/restaurants. Moreover, with unemployment still rising there is little sign that consumers' preference for value offerings is set to change, despite all the talk of 'green shoots'.

So while the rental element of the income pub owners generate from tenants should act as a shield for the business against deteriorating trading, conditions are so tough that pub groups are having to offer tenants concessions. For example, in order to stop struggling tenants going out of business Punch was providing £1.6m in monthly concessions per month when it issued a trading statement in late August. There is also the risk that pub owners will continue to face similar pressures to owners of other real estate, such as shops and offices, and be forced to permanently lower rents on troubled properties. And the sale of drinks to tenants - the other component of income from tenanted pubs - is also under pressure due to the poor economic conditions.

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Furthermore, the exclusive agreements through which tenants must buy drinks from pub owners - the so called 'beer-tie' - is currently coming under challenge from both politicians and campaign groups such as the Campaign for Real Ale (Camra), and the Office of Fair Trading (OFT) is investigating. While no one is suggesting the beer-tie should be abolished, the prospect of reforming it could prove costly for Punch.

One of the key methods that the group has been using to pay down debt has been pub disposals, but this is unlikely to help on the trading front. While Punch should get some credit for the aggressive approach it has taken to pub sales in an incredibly tough property market, it has had to sell some high-quality assets in order to get deals done. Better-financed rivals such as Fullers and Greene King have been overjoyed with the pubs they have taken off Punch's hands this year. The worry is that the quality of Punch's estate is being reduced in order to pay off debt.

That said, the £400m-plus of pub sales achieved in the year to 22 August has allowed the group to buy in its debt below face value, and a £350m rights issue in July also contributed to the debt reduction effort. However, as confidence has improved in both the equity market and in Punch's ability to service its debts, the price of its debt has risen. News of recent repurchases of the short-dated convertible debt did not include news of the price Punch paid.