That Greene King finds growth elusive is hardly contentious. Sure, its five-year record implies little but growth. Back in 2011-12 it generated revenues of a bit more than £1bn and operating profits of £239m. Fast forward to the financial year just ended and turnover will have doubled while operating profits will run at close to £400m.
However, most of that increase stems from the £763m acquisition of Spirit Pub Company in 2015, which added £700m to turnover, and management’s latest trading update shows that Greene King’s like-for-like revenue is down year on year – shrinking, albeit not so much as the UK pubs’ market.
Meanwhile, Greene King is spending heavily perhaps to do little more than stand still. Capital spending peaked at just short of £200m for each of 2015-16 and 2016-17. It may have dropped to about £160m in 2017-18, but even that will be well ahead of the rate of depreciation – £114m was charged in the 12 months to mid October and, in the past six years, Greene King’s capital spending has been more than twice its depreciation charge.
True, it could be that its bosses are writing off fixed assets too slowly. That would be an easy way to boost accounting profits and there is insufficient detail in the accounts to rule that out for sure. Yet it’s unlikely, as a comparison of the ratio of capital spending to depreciation among the UK’s leading pubs operators indicates that, if anything, Greene King – along with Mitchells & Butlers (MAB) – charges higher depreciation rates than the others. More likely, Greene King’s estate is in need of a thorough make-over and/or – like other pubs operators – it needs to spend to keep up in a declining market.
Yet that prompts the question – and it’s a generic one – whether a company in a shrinking market can justify heavy capital spending; indeed, whether it can justify anything more than the bare minimum since the excess capital spent might end up down the metaphorical drain. The deciding factors here are a company’s cost of capital and its return on the capital spent, though, for outside observers, both these of these figures can only be estimated. Even for insiders, the cost of capital is an estimate since it includes an equity component, which is not an explicit charge – like an interest rate – but is an ‘opportunity cost’, based on the returns that investors expect for choosing one opportunity over another.
Do the back-of-the-envelope sums for Greene King and the results look acceptable, just about. The big assumption is that operating profits continue at the rate established since the acquisition of Spirit Pub Co – at least £400m a year. That’s sufficient to generate a free-cash annuity whose value, on a per-share basis, would exceed the share price – almost 630p versus 580p.
It also produces a post-tax return on capital that, if applied to estimated levels of future capital spending in excess of the depreciation charge, would add more value into the mix. This is what I have labelled the ‘value of the growth potential’. It is a nebulous figure, but if – year after year – a company is churning out capital spending well above depreciation, you have to ask: surely it must have some quantifiable value?
Within a company’s internal controls, that question is certainly addressed. Each project is considered on its merits with cash-flow projections coming up with an expected rate of return and/or a net present value. Granted, such exercises often contain wishful thinking. Even so, they produce figures that look precise and feasible. Aggregate them across a group and the bosses have a grasp of the value likely to be generated.
My stab at the value of growth potential is a simplified way of doing that exercise from the outside. It produces estimated values that fall within a range of probabilities, but the chief aim is that the central valuations are based on sensible assumptions about, say, the profits likely to be generated, the tax likely to be paid, the likely cost of equity and debt and so on. Sure, I said in the opening paragraph that such exercises must not rely on ‘feelings’. In truth, there is always a touchy-feely element about them. Hence the need for a wide margin of safety between estimated value and price paid.
In Greene King’s case, the figures work out decently. It requires considerable pessimism to get valuations below the current share price while it’s easy to get estimates clear of £10 per share. For estimates to come in between £7 and £8, the group’s bosses don’t have to do anything that special – trim a bit of capex here, squeeze a bit of working capital there. Okay, in practice it’s not that easy; why would it be in an industry as constrained for growth as operating pubs? Even so, with the dividend payout looking under no particular pressure, I feel assured that buying shares in Greene King won’t be using spare cash to burn a hole in the Bearbull Income Portfolio’s pocket (see Bearbull, 11 May 2018). So half of the fund’s £40,000 in cash has now found a home.
