The relatively modest valuations attached to most pub shares suggests the sector is unloved, but the high yields and solid growth prospects of its major players and a number of potentially high-return special situations suggest it shouldn't be. Away from the headlines of pub closures and a consumer malaise, trading among the big listed pub companies has actually proved extremely resilient this year and the current round of corporate reporting is providing further grounds for optimism.
At the outset of 2012, it looked like things could turn out very differently. The industry faced the prospect of falling real consumer incomes combined with rising pub running costs and above-inflation drink tax hikes. However, pub owners have proved more adaptable than many (including us) believed. They have focused on food-centric growth strategies, value-for-money and cost controls. The sector has also done a very good job of negotiating 2012's big 'known unknown' - the Olympics - and its 'unknown unknown' - the very wet summer. "I think overall recent trading has been surprisingly good," says James Hollins, a leisure analyst at Investec Securities. "You've seen consumers being very committed to having an evening out and buying food and drinks."
Still, there are few signs of respite as far as the trading backdrop is concerned - consumers are still struggling, input costs continue to feel upward pressures and drink-tax increases of RPI plus 2 per cent stay in force. But following such a resilient showing in 2012, investors should be able to take comfort from the validity of the growth strategies pub companies have forged since the credit crunch, which feel increasingly tried and tested. "I don't think the themes are going to change that much," say Peel Hunt analyst Nick Batram. "Generally the pubs are all doing pretty solidly, although there are couple of interesting special situations."
| TIDM | Name | Market cap | Price | Forecast EV/ ebitha* | Forecast PE ratio | Forecast EPS growth | DY | 1-yr price change | Net debt/ ebitha |
|---|---|---|---|---|---|---|---|---|---|
| PUB | Punch Taverns | £45m | 6.7p | 9.0 | 1.0 | -23% | - | -35% | 8.8 |
| ETI | Enterprise Inns | £320m | 64p | 9.0 | 3.1 | -12% | - | 63% | 8.2 |
| SPRT | Spirit Pub Company | £366m | 56p | 7.2 | 10 | 10% | - | 42% | 7.6 |
| FSTA | Fuller Smith & Turner | £392m | 705p | 11.6 | 17 | 5.8% | 1.8% | 12% | 2.9 |
| JDW | JD Wetherspoon | £570m | 471p | 6.7 | 11 | 4.7% | 2.5% | 18% | 3.4 |
| MARS | Marston's | £659m | 116p | 8.9 | 9.1 | 11% | 5.0% | 21% | 6.3 |
| MAB | Mitchells & Butlers | £1.2bn | 283p | 8.0 | 8.9 | 10% | - | 9.2% | 5.4 |
| GNK | Greene King | £1.3bn | 602p | 9.8 | 11 | 6.7% | 4.1% | 32% | 5.8 |
| YNGA | Young & Co's Brewery | £285m | 630p | 10.9** | 18 | 8.0% | 2.1% | -0.4% | 3.1 |
Source: S&P Capital IQ, *Numis Securities and **Peel Hunt forecasts
Special situations
Given the large level of debt used in the sector and the large-scale ownership of freehold assets, a key valuation metric used when assessing pubs is cash profits to enterprise value (market capitalisation plus net debt). On that basis, the sector's two special situations, Spirit and Mitchells & Butlers, stand out as being cheap. JD Wetherspoon's seemingly rock-bottom valuation on this measure is a bit of a red herring because it holds leases rather than freeholds on most of its estate. That means its property-related liabilities are reflected in 'off-balance-sheet' rent commitments rather than 'on-balance' sheet debt.
The two companies are lowly rated for very different reasons. Mitchells is considered to have some of the best eating-out pub brands in the business, including Harvester and Toby Carvery. It is also considered a canny operator and the estate has a reputation for being well invested. However, investors have lost faith due to seemingly endless boardroom scraps as management and large shareholders have vied over strategy - a vehicle controlled by currency-trading billionaire Joe Lewis controls 26 per cent of the share capital while a vehicle of horseracing tycoons JP McManus and John Magnier holds another 20 per cent.
However, the recent announcement that the chief executive's job has finally been filled by Marston's former chief operating officer, Alistair Darby, provides hope that the market could start to focus on fundamentals, which could help power the shares higher. Broker Numis also predicts a resumption of the dividend with a 7.7p a share payment pencilled in for 2013, rising to 11.8p in 2014, equivalent to a 4.2 per cent yield at 284p.
Meanwhile, Spirit has an experienced management team in charge which the City has faith in. By contrast, its estate, which represents the 'good pubs' spun out from Punch Taverns last year, has significant room for improvement. The group owns a number of underperforming tenanted pubs that most analysts would like to see sold off and, as a whole, the business is in need of investment. However, if the food-focused turnaround strategy comes off, there could be very good upside on top of the strong gains made to date.
"I think Spirit and Mitchells are the more interesting part of the market for me," says Mr Batram.
High yielders
If Spirit and Mitchells offer the most interesting pub investment opportunities, it is arguably the three key big players in the sector - JD Wetherspoon, Greene King and Marston's - that are most boring. However, these companies have some very noteworthy attractions in the form of good and growing dividend yields and, based on recent impressive trading performances, solid growth prospects. "The companies that stand out for me are JD Wetherspoon and Greene King," says Mr Hollins. "They offer good resilience and growth."
While for much of this year and last, investors fretted about whether Wetherspoon was sacrificing margin for growth, recently reported full-year results were strong. The company's focus on no-nonsense value-for-money has underpinned the performance and shareholders should benefit from the ongoing lease-focused expansion of its estate. The business has also benefited from the Olympics and reported a sensational start to its new financial year, with like-for-like sales up 8.4 per cent in the six weeks since the end of July.
Marston's, the highest-yielding stock in the sector, has been making strong progress with its leisure-park-focused new-build strategy. Returns have been stronger than planned on these investments and there could be some good news to come from a revaluation of assets. The company has also benefited from the roll out of an innovative new franchise-like tenanted pub agreement that has reinvigorated performance in this part of the estate. The brewing business is also performing well thanks to its focus on premium, local brands. The multi-pronged strategy should continue to underpin growth for some time.
Meanwhile, Greene King's operational nous, its focus on food and taste for acquisitions make for a compelling story. Before the appointment of Mr Darby at Mitchells, Greene King had been talked about as a potential bidder. This no longer looks likely, but the company has not made an acquisition for some time and a noteworthy purchase could cause some excitement. Greene King also benefits from a slight bias in its estate towards prosperous parts of the country - London and the South East - which is helping support its performance.
Capital appreciation
Where pub companies are concerned, there's some truth in saying the streets of London are paved with gold. Trading from London-focused groups has been exceptionally strong during the consumer slowdown and, where reasonably-sized quality London estates have been available to acquire, rivals have fought hard to buy them. Young & Co's offers the most acute focus on the capital out of all the listed players and, following the sale of a stake in a brewing joint venture, the focus is now solely on pubs. The group has also benefited significantly from the acquisitions of the Geronimo pub company at the end of 2010, and was able to quickly scotch claims that it had overpaid.
West-London based Fuller Smith & Turner has been trading strongly, too, thanks to its focus on the capital, although recently the company has been buying high-quality assets in the home counties from debt-ladened tenanted pubs group Enterprise Inns. While the quality of the operations owned by Young and Fuller are reflected in the valuations of their shares, the premium ratings are justified by the asset backing and excellent track records.
Selling for survival
Two companies that epitomise the negative view that became attached to the industry during the credit crunch are Punch Taverns and Enterprise Inns. Their low earnings multiples (see table) are an indication of the back-seat role being taken by equity holders as the companies attempt to sell off properties in order to service debt. Enterprise is the more promising of the two from an equity investors' perspective but it is still locked into a disposal programme as it fights to survive. These pub groups are the sector's true outsiders with the odds stacked against them, but offer potential for significant upside should things go their way.
IC VIEW:
Based on the tough trading backdrop for consumer-focused stocks it is easy to write off the pub sector. However, during 2012 the sector has shown its ability to trade well despite the challenging conditions and the growth strategies of its major players underpin these attractions. There is also a diverse range of opportunities on offer for investors ranging from high-quality London assets to solid high yielders and turnaround plays.
