Follow directors out of Enterprise Inns

Earlier this year, we advised selling shares in Enterprise Inns following a 35 per cent rally in their price. As it turned out, that gain was the start of something much bigger, and our tip turned out disastrously. Indeed, since then, investors, having stubbornly focused on Enterprise's gargantuan debt levels for many months, decided the group's situation was not so perilous and that it could look forward to life after the credit crunch. The share price has now quadrupled, but in our view, the fundamental picture is not a great deal better than it was six months ago.

When it comes to the bearish case for Enterprise Inns, the best place to start still seems to be the group's debt. As trading has stabilised at Enterprise, and City analysts have become familiar with the covenants attached to the group's many different tranches of debt, the mood has relaxed and the possibility of a default now looks far less likely. That's partly because Enterprise's bosses have taken some tough decisions to tackle the mountain of debt. These include axing the dividend, which has been a bitter pill for some shareholders to swallow, and selling pubs by the hundred.

When management updated the market for Enterprise's first 41 weeks' trading of 2008-09, it had offloaded 277 pubs for £84m and expected pub disposals to generate over £100m this year. The trouble is, this will have little impact on a debt burden that has remained stubbornly high at around £3.8bn since 2007. Besides, given the tough conditions for selling pubs, Enterprise may have had to part with some of the higher-quality parts of its estate. This has definitely been the case with its rival, Punch, which has also been selling off pubs to pay down debt, but at a faster rate than Enterprise.

What's more, while the debt situation may no longer be the cause of quite so many sleepless nights for investors, there are still issues around it. Ratings agency Moody's downgraded its outlook for £275m of Enterprise's debt from stable to negative following the recent trading update. It cited trading difficulties at Enterprise as the reason. The group also still has to refinance £1bn-worth of its debt in early 2011. This remains something of a concern, given the fragile state of confidence in the debt markets. As a result, holders of the debt, rather than shareholders, are the ones who really call the shots. And the high fixed costs of servicing the debt mean that even small changes in trading will have a big effect on both Enterprise's profits and its share price.

Besides, on the trading front, signs of stability need to be set against the truly dire trading that Enterprise experienced in the previous 12 months. Indeed, in the 41-week trading update, Enterprise told shareholders that business failures among its tenants were occurring at a rate that was 50 per cent ahead of last year and were costing the group £2m in lost income every month. And many pubs that are staying afloat are only doing so thanks to support from Enterprise in the form of rent concessions. In July, 800 licensees were receiving rent concessions and special discounts, and the cost of this support to stave off further failures was running at £1.7m a month. In addition, the numerous 'value-for-money' deals being offered by pubs operators to their tenants mean that, for example, Enterprise is having to hold down the prices it charges tenants for beer, even though these sales represent a major component of the group's income.

The group doesn't only face challenges associated with torrid trading and battered debt markets, though. Its business model is also coming under attack. Parliament is investigating the so called "beer tie", whereby pubs owners, such as Enterprise, rent pubs to tenants on the condition that they only buy beer and other sundries from the owner. Meanwhile, the Campaign for Real Ale (CAMRA) has made a "super complaint" about the tie to the Office of Fair Trading.