Berenberg shares its latest thoughts on the performance of M&B and Ei Group, and how it’s affected their ratings.

Mitchells & Butlers

The note from Berenberg said, that while M&B still has its challenges, trading momentum is improving materially and a free cash flow yield of c15% is within touching distance, therefore it believes it is too cheap for a company with significant freehold backing and a balance sheet which has been significantly de-risked. It has therefore upgraded its rating to Buy and increased its target price to 360p.

“Following at least five years of sub-par sales growth and flat earnings, M&B’s lfl sales momentum has shown consistent improvement in recent quarters, culminating in 4.1% lfl growth in H1 2019 and 5% EBITDA growth,” read the note. “We think that is indicative of: (1) building momentum behind management’s wide-ranging operational improvement initiatives, and (2) the growing benefit of restaurant supply finally normalising (given c75% of M&B’s sales are ‘food occasions’). We think both of those tailwinds can continue.”

It continued: “In 2014, M&B’s net debt/EBITDA stood at 4.5x, with a GBP380m pension deficit (c1.2x EBITDA) on top. Today, bank net debt is down to 3.8x, and the pension deficit has been reduced to cGBP150m. Within three years (by FY 2022), net debt/EBITDA will be sub-3x and the pension deficit will be gone. That will make M&B vastly more investable, and should enable a step-change in returns to shareholders.”

Berenberg also noted that M&B’s pension deficit could be wiped out next year. “M&B is currently litigating against the pension fund trustees to change the rate of inflation used in calculating the pension funds’ actuarial surplus. A decision is expected next year, and if successful, the actuarial deficit would fall by cGBP150m, taking it to virtually nothing. While that would not automatically absolve M&B of its current contributions, it would certainly be a step in the right direction,” it said.

Ei Group

In the note on Ei Group, Berenberg said it believed Ei Group’s management continued to do an excellent job of creating value for shareholders. “However, with few obvious catalysts over the next 12 months, and the shares close to our price target, we struggle to justify EI Group as a new Buy here, trading at c10x FY20E EV/EBITDA with a c4% free cash flow yield. As a result, while we continue to believe in the strategy, we downgrade our rating to Hold,” it said.

The note continued: “At its core, Ei Group’s strategy to unlock value from its predominantly tenanted estate consists of: (a) shifting pubs to free-of-tie leases (which widens the range of potential buyers, increasing the asset’s value ahead of potential sale events), and (b) investing in pubs which it transitions to its own management (driving an increase in earnings). Given Ei has c3,500 tenanted pubs left, that machine has plenty of years left to run, with c110 pubs pa moving into its managed estate, and c50 pa going to free-of-tie leases.”

The analyst said that alongside a solid multi-year strategy, Ei is performing well operationally too. “Llf net income in the tenanted business grew a solid 1.9% in H1, while the managed business achieved 6.0% lfl sales growth (against a tough comparable of 6.6%),” it said.

Regarding of its new returns framework, the note said that with Ei now on sounder financial footing, “management used H1 2019 results to outline a new policy for returning cash to shareholders; 50% of all annual cash flow after capex, interest and debt amortisation will be returned to shareholders, while 20% of any future large asset sales will also be returned. We expect buybacks will remain the preferred method in the near term at least.”

The note continued: “Having sold the majority of its commercial properties division in March, it will take some time for Ei’s leased estate to re-build to a scale where an asset sale would move the needle materially.

“Earnings estimates are unlikely to move materially either, with tenanted sites (which have a smoother earnings profile) still making up the bulk of the business. Refinancing of debt could provide some upside to current estimates – most notably the secured bonds maturing in 2021 (GBP125m at 6.875%) and 2022 (GBP250m at 6.375%), which could likely be replaced at a rate that is at least 100bp lower. However, the total saving would still only be in the region of GBP4m-6m pa (on a PBT base of cGBP115m-120m).”