The UK’s leisure sector is polarising at an unprecedented rate, with quoted operators set to extend their competitive advantage and become more acquisitive, according to leading analyst Douglas Jack of Numis.
Jack said that going forward, “share prices are unlikely to shake off consumer concerns, but a tough economic environment should extend the quoted operators’ competitive advantage and market share.
“The quoted managed pubs and restaurateurs’ competitive advantage has broadened from market positioning and cost efficiency to include web-marketing and advertising”.
Jack continued: “For the quoted managed pubs/restaurant operators, particularly those positioned towards low-ticket value food, recent trading suggests that VAT-related price increases have generally been accepted by customers.”
The analyst said that due to hedging, quoted operators’ cost inflation should be muted in 2011. However, he also pointed out that, “much of independent sector is likely to suffer the full impact of higher cost”.
Jack said: “We estimate that quoted managed pubs/restaurant operators will need to increase average prices by c.4% to maintain cash margins in 2011 and c.2.5% in 2012 (assuming no VAT increase). This reflects food, beverage and utility costs typically averaging only c.33% of costs (including interest) in restaurants and c.38% in pubs, with the majority of the cost base rising by just 1-2% per annum."
The analyst believes that “with competitive advantages from scale broadening to include web-marketing and advertising, the managed pub/restaurant operators should become more acquisitive”.
He said: “Fuller Smith & Turner, Mitchells & Butlers and Greene King have the firepower to achieve this; Marston’s and The Restaurant Group have sufficiently high quality pipelines to not need to.
“Sub-sector equity free cash flow yields average 12% and EV/EBITDA ratings are at 2002-3 levels. Due to debt reduction/EBITDA growth (aided by current good returns on investment), there should be attractive equity upside even if forecasts are not upgraded and operators hold their current valuations.”
Quoted tenanted/leased pub estates
The analyst said that boosted by investment and tail-end disposals, quoted tenanted/leased pub estates are returning to average profit growth. “However, with beer/cider volumes falling by an average of 6.8% per annum in the wet-led pub segment, we believe like-for-like profit growth based on rental growth is unsustainable for operators that fail to adopt managed disciplines and central purchasing scale on all products.”
Key picks
Jack said that aided by eating out returning to strong growth in 2010, upgrade momentum has returned to most of the quoted operators.
He said: “We believe Domino’s Pizza, Fuller Smith & Turner, Greene King, Marston’s, Mitchells & Butlers and The Restaurant Group are best placed for forecast upgrades in 2011. In most cases, they also offer scope to re-rate.”
Jack said that downgrading of Enterprise Inns to Hold (from Buy), “reflects increasing pressure on tenants from higher inflation and falling drink volumes”.
The Restaurant Group was upgraded to Buy (from Add) to “reflect potential for strong earnings growth in 2011”.
Jack placed Domino’s Pizza as a Buy. “Recent weakness has brought a buying opportunity, in our opinion. On assumptions of just 3% like-for-like sales per annum, we estimate pre-tax profit growing to £150m over the next 10 years; even after returning over £0.65bn to shareholders.”
