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FTSE 350: Pubs and restaurants battle for 'premium' punter

The chase is on for the 'premium' market, but not everyone can win the race
January 26, 2017

It has become the buzzword of this sector, with seemingly every pub and restaurant going ‘premium’ with their offering. This is often centred around food, but also relies heavily on stocking the right craft ales and spirits. Fighting for the premium pound makes sense given that these consumers’ disposable incomes are less likely to be affected by macroeconomic factors. But not every company can win the race, and investors backing stocks in this sector will need to keep a close eye on how restaurants and pubs fare in what could be a tricky consumer environment.

A positive for restaurant and pub companies is that most of their costs are denominated in sterling and so there’s little impact on them from the drop in the pound. But there are still cost pressures. Management teams will have to carefully manage their supply chains to make sure they are controlling input costs – something airport and railway station concession operator SSP (SSPG) has recently been focusing on heavily.

Then there’s the national living wage, which mandates higher salaries for those aged 25 and over, and which will rise from £7.20 to £7.50 in April. While the absolute amount of wage increases per company seems containable for most, it is another cost that needs to be offset if margins are to be protected.

Business rates are another issue for the sector, particularly London and south-east focused pub chains such as Fuller, Smith & Turner (FSTA) and Aim-traded rival Young & Co's (YNGA). This is where a company such as Marston's (MARS) could have a defensive edge. Chief executive Ralph Findlay has said that, because his sites are less likely to be in expensive city centre locations, he is expecting to feel less heat from the government’s business rates review, which takes effect this year.

For the same reason, JD Wetherspoon (JDW) might also benefit from its broader geographic spread, but the value-focused group can’t escape the squeeze from the minimum wage rise. Effusive chairman Tim Martin regularly reminds investors that pub wages are about 30 per cent of sales. The group has tried to keep ahead of this particular curve, increasing wages by 5 per cent in 2014 and 8 per cent in 2015 – moves it made without the knowledge of the forthcoming statutory increase. But it’s unclear how much extra JDW will need to spend on salaries due to the new mandated level, and it’s arguably far more difficult for it to raise prices compared with rivals given its value focus.

Things don’t look straightforward for Mitchells & Butlers (MAB), either. The pub and restaurant group suffered a small adjusted operating margin drop recently due to a 5 per cent increase in wage costs, as well as investment in its estate. Chief executive Phil Urban has previously noted stiff competition for more than half its Harvester and Toby Carvery sites from rivals, and while it is shifting greater emphasis on to its premium brand, Miller & Carter, it only has 52 of these at present.

If proof was needed that chasing ‘premium’ wasn’t as easy as bumping up the price, consider the parable of Restaurant Group (RTN). The sector darling fell from grace last year after weak sales performances, and non-executive chairman Debbie Hewitt acknowledged one issue had been the “own goal” of above-market-price hikes at Frankie and Benny’s, which attracts a cost-conscious customer. New boss, former Paddy Power interim chief Andy McCue, has his work cut out.

A major competitor to all these businesses is, of course, Domino's Pizza (DOM), which is benefiting from the resurgence in takeaway convenience eating. Its multimedia prowess means it can directly market deals to customers, a successful approach given 81 per cent of delivered sales were made online in the 13 weeks to 25 September 2016.

It’s not easy to see where to fit the recommended offer for Punch Taverns (PUB) from brewer Heineken (HEIA) into all of this. This year will demonstrate if it was a true one-off, or whether vertical integration becomes a preferred strategy for the larger players wary of the craft threat.

Price (p) Market value (£m)PE (x)Yield (%)1-year change (%)Last IC view
Compass Group1,44923,82323.72.226.8Buy, 1,432p, 30 Dec 2016
Domino's Pizza3801,87998.22.019.6Buy, 341p, 24 Nov 2016 (adjusted for 3-for-1 share split)
Greene King7152,21411.44.5-16.2Hold, 691p, 9 Dec 2016
Marston's 1367839.75.4-10.9Buy, 136p, 24 Nov 2016
Mitchells & Butlers2691,1147.72.8-0.2Sell, 273p, 22 Nov 2016
Restaurant Group34469210.35.1-33.3Buy, 426p, 30 Aug 2016
SSP Group3981,89325.71.441.1Buy, 364p, 29 Nov 2016
Wetherspoon (JD)9381,03618.91.338.0Sell, 830p, 2 Nov 2016
Whitbread4,1187,54517.32.25.6Buy, 3,464p, 30 Nov 2016
 

Favourites: The shares of pizza chain Domino’s might be pricey, but we still think they are worth it given its strong organic growth and complementary acquisitions. We’re also sticking by Restaurant Group to see what changes the new boss will make: it could regain some lustre if consumers become more cost-aware. And with the numbers of people who travel globally constantly rising, it’s hard not to back SSP.

Outsiders: We’re circumspect about value-focused Wetherspoon. The stock had a somewhat inexplicable rise after the June referendum, but a trading update in November showed a contraction in like-for-like sales, while margins are under pressure as it has less room to raise prices.