Pubs cheer the sunshine

The latest round of trading updates showed that the easing of the terrible spring weather has had an immediate boost on turnover. Reports suggest that a buoyant start to the summer has added about £60m in additional sales for pub operators so far. However, the industry is still dealing with some deep-seated structural problems, and what looks like an enduring split between those companies focused on London and the south-east, and the rest of the country.

There's no place like London

There has been a growing realisation over the past decade, or so, that London has emerged more as an international city state along the lines of Singapore, rather than solely as the capital of the United Kingdom. The sense that the London economy, and by the extension the south-east, has largely detached itself from the rest of the country is amply illustrated by the pubs sector. Increasingly, the performance of pubs in London, or at least within its commuter radius, is becoming the gold standard within the sector, with valuations to match.

However, it isn't just location that has pushed PE ratios for the likes of Young & Co's Brewery (YNGA) and Fuller, Smith & Turner (FSTA) to an average of 22. The major point about these types of companies is that they have benefited from remaining largely managed businesses, appointing managers to run their pubs rather than relying on licensees to take up a tenancy. In addition, with an average debt gearing of only 42 per cent, both companies avoided using their balance sheets to finance a massive expansion.

In short, the London pub groups have been consistently better run, as well as benefiting from consistently rising property and land values. However, that can be a double-edged sword, as rising costs mean that margins on new pubs are lower and need more remedial action to boost profits. Young's, for example, has been carving out new venues within the basements of its existing properties as a way of boosting capacity and yield per pub.

Fuller's has taken a slightly different approach to expansion and has concentrated instead on expanding its estate within the pleasant market towns of the M4 corridor. It has bought up pubs at a cheaper price than the London equivalent, thereby tapping the affluence that radiates out into the capital's hinterland.

A ray of sunshine

"The pub industry is pretty simple," says Numis leisure analyst Douglas Jack. "When the sun is out, people go to pub gardens and parks. When it is cold, they stay at home under a blanket." This simple fact means pub companies with conservative balance sheets do not need London locations in order to thrive.

Marston's (MARS) and Greene King (GNK) have large diversified estates mostly outside of London and should also benefit from the estimated 20 per cent boost to earnings that good weather can bring. That's important because, according to broker Numis, these particular pub groups have high numbers of pubs that have outdoor spaces and gardens and they also have in common a continuation of their traditional brewing activities. Beer gardens attract punters on hot days and ensure that pubs with strong branding in the right areas can generate excellent returns.

Greene King has been a notable exponent of this approach, in particular with its Hungry Horse branded establishments - these have been generating like-for-like sales growth of 10 per cent over several years. The strength of its food offering, which plays well during the winter months, is another plus point for Greene King, as it has managed to attract well-heeled consumers who are otherwise reining in their spending.

Neither a lender, nor a borrower be

Better weather will also offer some respite to the other big pubcos whose business records have largely left investors crying into their pints. Punch Taverns (PUB) and Enterprise Inns (ETI) form a gruesome twosome when it comes to operational performance. They were constituted more as property development companies and used their balance sheets to acquire thousands of pubs on leases and freeholds in a mad dash for expansion. If you add in years of controversy over the treatment of tenants - which resulted in a plan for a formal regulator to oversee the industry - and both companies still look particularly exposed at the moment. Combined net debt at Punch Taverns and Enterprise Inns remains over £5bn and both companies are going through a painful process of shedding properties and renovating the better-quality pubs to increase their return on capital - the best pub groups can see a 15 per cent return on initial investment, significantly higher than Punch and Enterprise.

Where Punch and Enterprise are heading is probably best illustrated by the experience of Mitchells & Butlers (MAB). With net debt of £1.77bn, or gearing of 157 per cent, M&B is no less financially exposed than the other PubCos; however, it is much further along in its turnaround plan. The company has spent nearly £120m during the past two years on renovating its pubs, with the expectation that this will add additional sales of between £50m and £80m a year. It could be a while, though, before investors see a tangible return for all this effort. The company's pension deficit is a notable £100m and a triennial review is due this year that will determine how much the company has to contribute to stabilise the situation. The general view is that dividends won't return before the pension deficit issue is finally settled.

IC VIEW:

It is going to be an interesting quarter for pubs if the good weather continues, particularly with the weak comparisons from last year. Paradoxically, this might not be so positive for restaurant operators, which tend to lose out when the weather is good. Still, considering all that has happened since 2007, overall the industry looks in much better shape, with the focus now on improving returns from the existing estate rather than expansion no matter what the cost. However, investors still need to be selective when picking shares in the sector in order to avoid concentrating too much risk within a portfolio. So be aware that pub shares tend to do well at the expense of defensive stocks and will attract momentum-seekers.