Leading analyst Jamie Rollo at Morgan Stanley has said that pubs face an unenviable combination of weakening sales, mounting costs, and rising capex, so risks will likely remain high, and valuations could hit new lows. In a note entitled “Pub Companies – A Flat Pint”, Rollo focuses the impact of these headwinds on JDW, M&B and Greene King.
Rollo said: “Like-for-like sales for the pub operators have remained dull (c.0.5% YTD) despite a benign economic backdrop, impacted by high supply growth in food-led outlets and changing consumer habits. With the prospects of weakening GDP and rising unemployment, LfLs could easily turn negative, especially as current run-rates are well below the c.4% growth seen before the downturn in 2008/9.
“Operators face a wave of cost pressures over the coming years, with increases in labour (National Living Wage, National Minimum Wage, Apprenticeship Levy), utilities, purchasing, business rates, and depreciation as companies up their investment. In total we see c.3-4% gross annual cost inflation in the next few years, which after mitigation would require 2.5-5.0% LfL sales growth to keep margins flat.
“Rising competition also leads to shorter brand life cycles, so capex is rising for everyone, which along with slowing sales and rising operating costs creates a toxic mix. While the market is aware of cost pressures, FCF implications may be more of a surprise. We now don’t see much deleverage, which could put dividends at risk, and could raise the spectre of equity raises as during the last downturn. We do not see any imminent issues on our current forecasts, though note that Mitchells & Butlers is within c. 10% of its securitised debt’s restricted payment tests, which permit it to upstream dividends to the PLC. It has plenty of flexibility to increase this headroom, but uncertainty could weigh on the shares.
“We downgrade Mitchells & Butlers to Equal-weight with a 260p price target to reflect the forecast cuts we made after the FY16 results, lower FCF generation, and peer group derating. We think the company is delivering a sensible strategic plan, and the valuation is too depressed given the freehold backing, but given the reduced optionality in the business and the risks laid out above we think investors need to have high confidence in management’s turnaround.
“Where could the industry surprise to the upside? We think a ‘staycation’ trend and a positive impact from consumers recycling increased wages could serve as some support to the industry, and note that our house GDP forecasts have been
revised upwards since the EU Referendum. Supply growth is also slowing sharply as even the best operators struggle. Government action could also serve as a catalyst, either through slower or lower wage increases, or changes such as VAT reform which could make pub pricing more competitive.
“Our base cases for the managed operators assume LfL sales growth remains dull over the next few years. We assume JD Wetherspoon continues to outperform its peers on sales, in line with its history and with a competitive low-price offer that stands to benefit from consumers trading down in a downturn.
“For Greene King and Mitchells & Butlers, we assume a run-rate of c. 1-1.5% LfL growth, supported by the companies’ investment programmes, which we think addresses underinvestment in portions of the estate. In Greene King’s case, we attribute this mainly to the Spirit acquisition, though we have also noted that both Spirit and Greene King churned estates at a lower rate than peers, leaving a potential ‘tail’ of unprofitable pubs.
In Mitchells & Butlers’ case, this is focused on some of the legacy brands such as Harvester, and has been acknowledged by the company shortening its capex cycle from c.10 to c.6 years. For both companies, our bull cases reflect c. 2.5% growth,
approximately the industry average from 2013-15.”
