09.01.2009

It’s by no means a certainty, but there is a decent chance the stock market could stage a recovery in 2009 should signs emerge of a floor to the world’s economic travails. In such a happy event, the shares which are likely to rally the most are companies’ that currently look among the most distressed yet should be able to trade through a downturn. From that perspective, it can arguably be regarded as a plus point that All Bar One to Harvester pubs group Mitchells & Butlers, our high-risk tip of the year, recently appeared on the critical list of our recent Company Watch corporate health check feature. The problem with Mitchells, which it shares with several other big pub companies, is that its debt looks far too high given the deterioration in trading conditions that the pub industry is facing. Pub beer sales, for example, are falling at an annual rate of 8.1 per cent.

However, Mitchells recognised its problems early and its debt structure should help it cope with the current problems. Most of its debt is in the form of securitisations (£2.3bn of the £2.73bn group total), which is a form of financing where debt is secured against income producing assets. The terms of Mitchells’ securitisation look relatively favourable and broker KBC Peel Hunt, which has conducted extensive research into the pub industry’s debt mountain, calculates that even a 10 per cent drop in revenue would not cause Mitchells to breach any terms of the securitisation. That said, if a breach did occur then shareholders lose their claim to the company’s cash flows and, in the worst case scenario, lenders could take over the whole show.

More share tips and updates...

However, it is the group’s short-term £550m loan facility that is the most pressing issue. This has to be paid down to £400m by the end of 2009 and reduced to £300m by the end of 2010. By the time Mitchells announced its full-year results six weeks ago it had whittled this debt down to £475m and announced a range of measure that should help continue to bring in the cash. The dividend is being scrapped, which will save £57m a year based on the 2007 payout. Meanwhile the group is reducing capital expenditure from last year’s £193m to £120m, and it hopes to sell some of its pubs, although the market is extremely weak. So KBC believes that Mitchells will be able to pay back £144m of borrowings this year and £129m in 2010.

Mitchells is also in a good position to manage the underlying business in survival mode. The group’s estate is regarded as well maintained and therefore less at risk from reduced capital expenditure. What’s more, Mitchells manages its own pubs rather than renting them out to tenants, which should help it respond sensibly to deteriorating conditions by offering well-targeted promotions, for example. Indeed, the 1 per cent rise in like-for-like sales that the group reported for the eight weeks to 22 November suggests that Mitchells is living up to its reputation as one of the best pub operators in the business.

However, there is no getting around the fact that trading will be much tougher this year. Annual costs are expected to rise by £30m due to increased food and utility prices and there’s an extra £20m of regulatory costs to bear, mainly associated with the minimum wage. While the group is expecting to make £20m of annual savings, it still needs to grow like-for-like sales by 3 per cent for operating profits to stand still- an unlikely target given the current trading backdrop. And because of the high level of debt and related financing costs, the impact of falling sales will have a magnified impact on Mitchells profits and earnings per share. On the plus side paying down debt has a reverse effect.