Wetherspoon still fighting Covid side-effects

Few UK-based investors need much of an introduction to JD Wetherspoon (JDW), or an explanation of its offering. Starting from a single pub in north London in 1979, it has become a staple of the British high street.

Founder and chairman Tim Martin’s simple idea of providing customers with cheap pints and hot meals in big venues that can manage high volumes has been very well executed. JD Wetherspoon has risen to becoming the nation’s third-biggest pub operator – behind only private equity-owned Stonegate Pub Company and Mitchells & Butlers (MAB).

Not only that, but until Covid-19 hit the company was admirably profitable. OK, its low-cost offer meant its margin wasn’t quite as healthy as some of its peers – between 2017-19, it made an operating margin of 7.7 per cent, compared with 11.5 per cent at Mitchells & Butlers, 12.5 per cent at Marston’s (MARS), and 14 per cent at Young’s (YNGA). But its sales volumes were so high that this didn’t really matter – in each of those years, it generated an operating profit of over £100mn.

It did this by growing market share at a time when pub-going was generally in decline. According to the British Beer and Pub Association, more than 14,000 UK pubs, or around 24 per cent of the total disappeared between 2020 and 2021. That left an estimated 46,350 at the end of last year. The decline appears to be accelerating again this year, with 50 pubs a month closing between June and September, according to Altus Group. It said the number of pubs now left in the UK has fallen below 40,000.

The pandemic clearly hasn’t done the industry any favours. Even with extensive government support through measures such a the furlough scheme and relief on business rates, pubcos have seen debts pile up. Rent payments were deferred rather than forgiven, and the return of people back to pubs has been slower and less frequent than operators might have expected, particularly in cities where hybrid working has curtailed after-work drinks.

The result is that many companies that have yet to fully rebuild sales are battling a series of pressures – input costs are rising, consumer spending is weakening and the cost of servicing higher debt burdens is growing, at best, in line with interest rate increases.

Covid-related hangover

JD Wetherspoon has certainly felt the after-effects from this difficult period – after a 35-year unbroken run of profitability, it has suffered three successive years of losses, although exceptional items including a £27.8mn payment from HMRC to settle a historic dispute on the VAT treatment of slot machines and a £53mn gain on the notional value of interest rate swaps meant it declared a statutory pre-tax profit of £26.3mn in its latest full-year results, released last week.

Excluding one-offs, its cumulative loss over the three-year period has topped £240mn and it has burned through £125mn of cash. 

Even after tapping shareholders for more than £230mn through two separate rights issues, its net debt excluding leases grew to £892mn at the end of July – an increase of £46mn on the prior year and £166mn on its 2019 year-end. 

Including derivatives and lease obligations, net debt was £1.29bn at its July year-end – or around 7.7 times cash profit of £167mn. Wetherspoon has agreed covenant waivers with its lenders until October next year on the proviso that it maintains around £100mn of liquidity.

The company will no doubt be hoping that a normalised period of trading by then will help it to generate enough cash to pay down some of its borrowings. When announcing its year-end results last Friday, the company said trading for the nine weeks to 2 October had been more promising, with like-for-like sales increasing by 10 per cent on the same period a year earlier. 

A big plus point is that the interest rate on a major portion of this debt is quite low. The company has used swaps to effectively fix interest rates at 1.24 per cent, excluding bank margins, until 2031. However, the total cost of its debt last year (including the margins) stood at 4.46 per cent.

Costs elsewhere in the business continue to climb. As furlough support unwound, employee payments almost doubled to £692mn last year. According to Numis, Wetherspoon’s labour cost-to-sales ratio has jumped from 31 per cent in 2019 to 40 per cent. This has been “the single most important source of margin erosion”, the broker said. 

With wage inflation in the hospitality sector running at 7 per cent in the year to September – comfortably ahead of the 5.5 per cent average national pay increase, according to the Office for National Statistics – the company is likely to face further pressure to raise pay to recruit and retain staff. 

Although energy costs are hedged until the end of next year, it has decided against hedging further into the future given current prices. If these remain elevated, however, the company faces a £100mn increase in its energy bill from 2024 onwards, according to Numis.

On top of this, Wetherspoon is having to spend more on upgrading its pubs given that it had slowed investments during lockdowns to preserve cash. Total capital investment more than doubled to £127mn last year. 

The pub chain is likely to generate more revenue this year – analyst consensus is that sales will exceed pre-pandemic levels to reach £1.87bn, according to FactSet, which should allow it to pay down debt. Around £100mn advanced to the company through the government’s Coronavirus Large Business Interruption Scheme is due for repayment by next August.

The company can also use the proceeds from disposals of the 32 pubs it has recently instructed property agents CBRE and Savills to sell. However, getting rid of these would bring the number of outlets it runs down to 855, or back below the level it was at in 2012, and well below the 955 pubs at which it peaked in 2015.

Glass half-empty?

This raises an important question about growth, particularly given its high-volume, low-margin business model. 

There is an argument that JD Wetherspoon could be a net beneficiary of the cost of living crisis, as people switch from more expensive pubs to its value-focused offer. 

It could also eke out gains by continuing to grow its share of a shrinking market – there will certainly be smaller pub operators facing similar commercial pressures but who don’t possess the same sort of clout to fix such a large portion of their own interest costs.

The more worrying scenario, though, is that customers whose household budgets are already stretched just cut out visits to pubs entirely.

This seems to be the prospect that Martin fears most. In his commentary on the company’s latest results, he said lockdowns had led to many dyed-in-the-wool pubgoers filling their fridges with supermarket beer, adding that it has been “a momentous challenge” to persuade them to return. 

It’s not yet clear that all of them have. In a mid-July trading update ahead of full-year figures, the company said sales of draught ales, lagers and ciders, which have historically been the biggest contributor to pub sales, were down by 8 per cent – perhaps indicating that demand from core drinkers has some way to go to recover. Thankfully, this was at least partially compensated for by higher sales of spirits (up 4.4 per cent), cocktails (up 18.6 per cent), food (up 2.1 per cent) and hotel rooms (up 8.4 per cent). Sales from its 48 Lloyds outlets, which play music and are popular with a younger crowd, were up 6 per cent.

JD Wetherspoon’s market capitalisation has fallen from around £1.6bn since its 2019 year-end to a current level of just over £650mn. Although the shares rallied by as much as a fifth in the days following the results, the share price continues to suggest investors expect earnings growth to remain subdued. 

The company has continued to make investments – it has spent £158mn since January 2020 buying new pubs and converting leasehold outlets into freeholds – but some of its estate looks tired and it is hard to disagree with broker Liberum’s view that Wetherspoons is in need of a repositioning.

Where it generates the cash to do that is another matter. Selling pubs now offers a quick fix but it pushes out earnings and growth prospects even further into the future. A short-term high followed by a gloomier reassessment of future prospects is a feeling that may be familiar to many of its regulars.