Investment Column: Pubs toast food, value and flexible finances
Friday 20 August 2010
Pub operators raised a glass to the football World Cup and early summer sunshine, toasting a much-needed boost after a torrid two years.
But concerns are already growing that the tournament in South Africa and balmy weather may have been the calm before an impending storm, given that rising taxes and public sector job cuts are likely to take their toll on food and drink takings at boozers around the country.
After a tumultuous two years for most groups, when record numbers of pubs closed, there are reasons to be both fearful and cheerful at the prospect of buying shares in pub operators, including those with restaurants and associated brewing businesses.
Although most operators are leaner and meaner than they were before the credit crisis – and certainly many have continued to reshape their offer towards higher-margin food menus – the recession has left behind a group of operators that are in contrasting states of health.
In fact, the words of the legendary investor Warren Buffett that "you only find out who is swimming naked when the tide goes out" seem particularly appropriate when considering the investment case for pub companies.
Although the balance sheets of the UK's two biggest pub operators, Punch Taverns and Enterprise Inns, are better than two years ago, both companies are still burdened by a combined net debt of more than £6bn. All that debt had seemed a good idea before the credit crisis reminded us of the dangers of too much leverage.
As a result, they are still in the process of offloading pubs to pay down their debt. This means that Punch Taverns and Enterprise Inns – which still have more than 14,000 pubs between them – are having to sit on the sidelines as their nimbler and less debt-laden rivals expand and reshape their estates.
These contrasting prospects are reflected in a sizeable gap in the 2011 forecast price-to-earnings ratio of just 3.6 at Enterprise Inns and 5.5 at Punch Taverns, compared with a loftier 11.8 at Mitchells & Butlers (M&B). The average for the sector is around 8.
While such lowly valuations for Punch and Enterprise may tempt some investors – in fact we tipped Enterprise Inns as a "speculative buy" recently – City analysts are also concerned by their big estates of tenanted pubs, which have traditionally leant towards sales of beer instead of food.
We much prefer pubs that have the flexibility to grow their estate and invest in the four Fs: food, females and punters in their forties and fifties. For these reasons, we put JD Wetherspoon, M&B and Marston's on our buy list. Above all, we think that Wetherspoon is the pub operator to watch over the next year and beyond. The fact that Wetherspoon trades on a 2011 price-earnings ratio of 11.2 means there are cheaper pub shares out there, but we think the operator will benefit from cash-strapped drinkers' search for a cheap pint and pie.
Its recent move to start serving café lattes and cappuccinos for 49p between 7am and 9am is a further example of how Wetherspoon is stretching its offer. Such moves and the group's plans to add 250 new pubs to the end of 2014 are key reasons why analysts at KBC Peel Hunt, which calls Wetherspoon a "category killer", have slapped on it a share price target of 600p.
An even more radical reshaping of its estate is under way at M&B, where investors hope that its shareholder battles will no longer be splattered all over the business press.
Under its new chairman, John Lovering, the former chair of retailer Debenhams, M&B is to focus on six core brands, including Harvester, Toby Carvery and Vintage Inns, and to ditch its non-core chains.
To boost its plans, M&B has recently raised more than £130m by selling its Hollywood Bowl operation and 52 lodges, including a sale and leaseback deal on eight restaurants linked to the accommodation.
In a nod to his background, Mr Lovering also wants to focus his six core brands on locations with high footfall, such as retail parks.
Similarly to M&B, Marston's has delivered tasty food sales recently, particularly at its 488 managed pubs.
While the performance at its 1,671 tenanted and leasehold pubs has not been so rosy, we are encouraged by its plans to move about 600 on to a new retail agreement, which is similar to a franchise and should incentivise publicans, compared to just 88 now.
Overall, the next 12 months will present all pub operators with tough trading conditions, as household budgets get squeezed.
But a handful of operators should continue to benefit from grabbing one of the most enjoyable parts of discretionary spend for many consumers.
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