Bullish Scottish & Newcastle brews up a winter warmer for UK Leisure plc

Pubs and brewing group helps to soothe investor fears after Wetherspoon's tale of woe

Scottish & Newcastle has never been a company renowned for its conservative viewpoint. Indeed the brewer's chairman, Brian Stewart, is famed among the analyst fraternity for his sunny disposition. So it was with something of a pinch of salt that the market took yesterday's affirmation from the company that life was pretty rosy.

On the plus side S&N, owner of breweries stretching from Tornio in Finland to Khabarovsk in Russia's Far East, reported interim figures that were bang in line with City expectations. Pre-tax profit grew 28 per cent to £309.8m before an adjustment of £75.6m, relating to amortisation of goodwill and exceptional charges. Excluding exceptional items, pre-tax profits were up 27 per cent at £234.2m.

Despite pre-results jitters at the group's low level of dividend cover (just over one times), the half-year payout was raised by 3 per cent, broadly in line with inflation. This helped the shares to rise by 14p to 466p. There were also positive noises about the beer market in Russia, where through the UK brewer's £1.2bn acquisition of Finland's Hartwell in May, it owns 50 per cent of the leading Russian brewer – Baltic Beverage Holdings. S&N held firm to its forecast that the Russian beer market would grow by 10 per cent this year and next, in spite of recent slower sales.

And perhaps most significantly from the battered vantage point of the UK leisure sector, S&N's managed retail business achieved underlying like-for-like sales growth in the period of 7 per cent. This latter piece of news came as a particular relief given the ongoing carnage in the managed pubs sector, with last week's profits warning from former sector darling JD Wetherspoon following hot on the heels of the near collapse of Slug & Lettuce operator SFI.

To strengthen its defence, S&N points out that just 10 per cent of its 1,500-strong pubs estate is located in the high street, where heightened rivalry for the leisure pound is taking its toll and even well-regarded operators such as Luminar are being forced to discount to compete. S&N did see some discounting in the off-trade, but Ian McHoul, the finance director, dismissed this as mainly an inevitable effect of the World Cup and heavy promotions from the likes of Carlsberg.

"Wetherspoon is wet led whereas our product offering is much more balanced [between drink, food and lodging]. Plus as the market leader we do not lead the price down," Mr McHoul adds.

S&N also provided some clarity about its much heralded move to realise some value from its managed pubs estate, confirming that it expects to raise between £600m and £700m from the sale of about one-third of its outlets by April 2003. The group said it had made "significant progress" with plans to sell the initial tranche of 600 pubs, which are mostly unbranded community outlets in regional towns across Britain. Mr Stewart said the group was talking to "several" parties about selling the properties through a deal that would allow the brewer to retain a contract to manage the pubs and control sales of its beer brands such as Kronenbourg, Foster's and John Smiths. The move follows on from S&N's sale-and-leaseback deal in 2000 of about 450 pubs to the Royal Bank of Scotland.

But lurking behind the brewer's "take courage" message was continuing uncertainty about just what strategic direction S&N is seeking. For a start, the so-called sale and manage-back deal does nothing to progress what the City has long been clamouring for S&N to do: turn its back on selling beer through its pubs and focus on brewing beer through its extensive network of international breweries.

Part of the concern, analysts say, is the weakening consumer environment, with an exceptionally wet summer across Europe just setting the tone for what many expect will be an equally difficult winter. Although S&N professed itself content with 7 per cent sales growth at its pubs, it was shy of the 10 per cent growth the group said it was targeting at the start of the year.

Nigel Popham, at Teather & Greenwood, says: "What they achieved in pubs was nothing to write home about. It was no more than what you'd expect given the sorting out they've done and the money they've invested. I would be more circumspect than they are. If they can grow their profits year on year in the second half they will do quite well."

While the past two years has seen S&N transform itself from a national brewer into a significant player on the global beer scene with the purchase of Kronenbourg of France in 2000 and Hartwell in May, analysts argue that the company still needs a major shake-up if it is to have a further role in the consolidation game that has seen the world's largest brewers jockey for position in emerging markets to compensate for maturing western markets.

But S&N is reluctant to sell its pub estate too quickly because it contributes one-third of the group's profits. While pubs disposals will boost the group's weak cash flow generation, they will dilute earnings growth, forcing S&N to tread carefully. "There are no easy fixes," Andrew Gowen, at Lehman Brothers, says.

Much will ride on who S&N chooses to step into the shoes of Guy Dickson, the group managing director, when the 23-year S&N veteran retires at the end of December and Mr Stuart's current dual role is split. The group said yesterday it did not expect to name a chief executive until early next year. The smart money is on an outsider with international marketing experience who can maximise the potential from S&N's recent forays into Eastern Europe and India. But, says Stuart Price, at WestLB Panmure: "There still remains a danger that the candidate will not change the culture within S&N too much. That's not what's needed in our view."

For now, S&N needs to remain focused on concluding its pubs deal. The cash raised will allow the group to chip away at its £3bn debt mountain and possibly squirrel something away for further acquisitions overseas. It must also hope that the onset of winter in Russia doesn't diminish the population's new-found enthusiasm for beer instead of vodka.