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Raise a toast to JD Wetherspoon

JD Wetherspoon is one of the UK's best pub groups and, looking through the debate over its margins, there is a clear opportunity for value investors
November 28, 2013

There are few voices likely to be raised against the proposition that JD Wetherspoon (JDW) is one of the most successful pub companies established in the UK. Investors who backed the company from its initial public offering 20 years ago will have seen a 10-fold return during that period. Nevertheless, JDW defies easy analysis, partly because of its unique almost wholly leasehold structure, and also because of a business mix that is skewed heavily towards food service and its accompanying variable profit margins. Indeed, after enjoying a period of stable profit margins, higher marginal costs, changing tastes and beer taxes have combined to cut the average return from the company's pubs. However, the key point now is how the company responds to these problems and, so far, the evidence points to expansion as being the most likely solution. But recent margin pressures mean the market looks like it is now undervaluing this top-line growth.

IC TIP: Buy at 702p
Tip style
Value
Risk rating
Low
Timescale
Long Term
Bull points
  • Pub groups look ready to expand
  • Improving cash flows
  • Pub openings to offset lower margins
  • Best value among the "quality" companies
Bear points
  • Still faces ongoing cost pressures
  • Unimpressive dividend yield

The pub sector generally seems at the point of loosening the tight capital controls that made the paying down of gigantic debts built up during the boom years a priority. Now with balance sheets looking in a far better state, even at the sector's more troubled companies, the feeling is that gradual expansion is a realistic option, particularly after an acceleration in like-for-like performance in the sector since the start of 2013. That is certainly the impression that JDW gave in its recent first-quarter update where the total number of pubs slated for opening this year was upped from 30 to between 40 and 50.

This is important as pub openings are a key driver of long-term EPS growth. For example, despite recent margin disappointments, Investec analysts calculate that the additional pubs will add 2p extra to EPS in 2016, taking it to 64p once they are properly up and running. The broker bases these forecasts on the expectation that JDW will open around 35 pubs in 2015. The additional openings will also help to drive free cash flow - Investec estimates that free cash flow yield will top 8.7 per cent this year and grow to 9.5 per cent by 2015.

JD WETHERSPOON

ORD PRICE:702pMARKET VALUE:£885m
TOUCH:700-703p12-MONTH HIGH:774pLOW: 483p
FWD DIVIDEND YIELD:1.8%FWD PE RATIO:12
NET ASSET VALUE:171pNET DEBT:221%

Year to 28 JulTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20111.0766.835.312.0
20121.1972.441.312.0
20131.2876.954.012.0
2014*1.3678.448.112.0
2015*1.4690.056.312.6
% change+7+15+17+5

Normal market size: 1,000

Matched bargain trading

Beta: 0.47

*Investec forecasts, underlying PTP and EPS figures

Those forecasts look achievable given that first-quarter trading has started briskly, with the key like-for-like sales figure in the first quarter showing robust growth of 3.7 per cent. The update also showed a 0.3 percentage point decline in operating profit margin, though, to 8.3 per cent. That's off from a 2009 full-year peak of 10.2 per cent.

The margin squeeze inevitably leads to accusations that management is chasing revenue growth at the expense of profitability, especially as the five-year compound annual revenue growth rate is an impressive 7.1 per cent. There is probably some truth in this, but part of the extra costs are tied to an extended food service and, given that food and raw materials costs have soared over the past few years, the pressure on margins would exist whatever option management decided to take. In any case, the opening programme should offset margin pressure and should margins stabilise, or even - dare we suggest - start to improve, then top-line growth should begin to drive really impressive earnings improvements.

There are other negative factors to consider. Despite chief executive Tim Martin's regular moans on the subject, there is no quick answer to the tax disparity that exists between supermarket booze and the pay-at-source taxes that pubs have to cope with. Any real change to the system currently looks deadlocked in a coalition government that has fallen behind with its legislative agenda.