Following the news last week that Whitbread is to sell Costa Coffee to Coca-Cola, leading analyst Jamie Rollo from Morgan Stanley asks what’s next for Whitbread, now the focus has shifted to Premier Inn?

The note from Morgan Stanley read: “Following the announcement that Whitbread is to sell Costa Coffee to Coca-Cola for £3.9bn at a premium 16x EBITDA, questioning on the call about any plans for a separation of the hotel real estate, and activist Elliott’s announcement that it “looks forward to continuing to engage with the company to maximise the value of the remaining businesses”, a key market debate now is whether this might lead to the remaining Premier Inn & Restaurants (PI&R) business being separated, restructured or sold.

“Following Friday’s 14% share price move, Whitbread’s EV has risen to £10.1bn, including the pension deficit and based on FY20e net debt (to include the German acquisition). Net of Costa’s cash proceeds, the EV of PI&R is therefore £6.3bn.

“Our Feb-19e PI&R EBITDA forecast is £683m, which net of £36m of PLC central costs (which might rise a little due to dis-synergies) gives proforma EBITDA of £647m, rising to £695m in FY20e. Hence, the business is trading on a cal 2019 EV/EBITDA of 9.2x, equivalent to 14.0x cal 2019 P/E. Net of the real estate value (£4.6bn at last published mid-point), this implies the PI&R opco is trading on ~4.5x EBITDA.

“Peers include US Hotel REITs (11.5x 2019 EBITDA), European owned/leased hoteliers (5-10x), and global asset light peers (14.5x). We note that ~15% of PI&R EBITDA comes from Pub Restaurants (where peers are on 7-8x). Premier Inn is a strong hotel company, enjoying leading KPIs on occupancy (~80%), Tripadvisor (average score of 4.5), direct distribution mix (95%), annual unit expansion (6%), and real estate backing (65% freehold tenure mix). The main business negative is it has been experiencing modest RevPAR declines, reflecting cannibalisation, high supply growth and a dull UK economy. Our proforma model shows a business generating a ~7% EPS CAGR post the Costa sale, mostly driven by expansion.

“Premier Inn is unique in having both substantial domestic scale and also substantial real estate, a function of its UK brewing / pub heritage. By contrast, the global hotel operators now mostly only manage or franchise third party hotels, and most European asset heavy hotel operators are relatively small. In addition, the large global players are relatively small in the UK (e.g. Premier Inn is 3-7x as large as Holiday Inn, Hilton or Marriott), and the hotel industry is fragmented. Continued commentary by activist investors Elliott Advisors and Sachem Head for further “value optimisation”, as well as Q&A on the call covering the company’s future options, mean a key market debate is whether the Costa disposal could lead to Whitbread aligning its business model with peers by separating its real estate and / or take part in consolidation.

“Whitbread reiterated on the call its confidence in its unique business model, and said it has no plans to reduce its freehold content. The company has laid out the merits of its model many times: strategic in terms of property ownership providing development potential (one-third of new rooms over FY16 and FY17 were extensions of existing hotels), product advantages (better invested rooms and with a superior food offer to peers), cheaper funding (debt is cheaper than operating leases), and earnings security (ownership confers higher margins than leases, particularly in a cyclical industry). We continue to model the company opening c. 4k hotel rooms a year, mostly in the UK.”

Rollo says that while separating the business could be a plausible strategy, there are some significant caveats. “First, splitting the Hotel business would risk losing the structural benefits listed above that PI enjoys from full control of its product (brand, operations, property). Second, these three businesses have very different characteristics so would appeal to different owners, requiring a 3-way split, which would be complex. Third, the highest quality element of the hotel value chain is the brand / franchise value, but this is only 10-15% of total value, so to break a business up to extract a small part risks the tail wagging the dog, and the overall value is still heavily reliant on the value of the real estate and opco.

“Whitbread has alternatives: use the cash to accelerate Premier Inn’s expansion in Germany. The company highlighted on the call the recent £300m Foremost deal which gives it critical mass in Germany, and the potential to replicate the scale and success of the UK business.

“We have written in detail about Whitbread’s German aspirations in the past and concluded that the company would need to make a sizeable acquisition in Germany for it to be a meaningful business, not least as the UK operations are so substantial and so profitable. If Germany needs to represent, say, 20% of UK Hotel EBIT to be on investors’ radar, this implies ~40k rooms there (vs its UK 70k rooms), but we estimate this would either take time (25 years if expansion is organic), or significant investment (a c. £2bn acquisition assuming a generous 8% post-tax ROCE). However, a transaction of this scale could impinge on the plans to return a “significant majority” of the Costa proceeds to shareholders, or would require it to issue equity (potentially dilutive with its current valuation multiple well below where private transactions have traded).”