M&C Report takes a closer look at the full-year results for Marston’s, the brewer and pub operator, and talks to chief executive Ralph Findlay and Peter Dalzell, managing director of Marston’s Inns & Taverns. New franchise agreement Marston’s revealed that it’s introducing a new version of its franchise agreement called the Pub Franchise, which will incorporate the two community pubs formats from its managed division. The formats are called Village and Homestead, aimed at village and suburban sites respectively. Four sites based in the Midlands were converted to the new franchise agreement in the summer, and Findlay told M&C Report that the agreement structure is "broadly the same" as for its Retail Agreements and features incentives to maximise turnover. Marston’s said the four trial sites are "all achieving positive results". Findlay said: "I think the Pub Franchise will be expected to achieve a similar return on capital as on the Retail Agreement." This is "typically about £50,000 per pub", he said. The company said it expects to extend the agreement further into the estate in 2013. Findlay said he was "not going to be drawn on numbers". "One of the strengths of the model we’ve got is complete flexibility about whether the pub is managed, franchise or leased and we will decide on the best model for each pub." Dalzell told M&C Report that the Pub Franchises will operate within the tenanted and franchised division. He said existing sites managed, tenanted or Retail Agreement sites could be converted to the new agreement. In terms of the new two concepts, Marston’s said: "Our primary objective is to offer traditional pub entertainment and everyday value food and drink in a traditional ‘community local’ pub environment. Typically, these are ‘wet-led’ pubs, although food sales are increasing and now represent 28% of sales mix. We expect food sales mix to continue to increase as a consequence of greater focus. Future investment in these pubs will be focused on maintenance capital and improving standards in existing sites." Minimum pricing and alcohol consultation Findlay said the proposal to introduce a 45p per unit minimum price "will perhaps be a benefit to pubs in the sense that it will encourage people to drink in pubs rather than staying at home". Pointing to concerns about competition law, Findlay said: "Whether it will come in I don’t know. It may be some time off." He said that more of a worry was the proposal to allow conditions relating to health to be added to local licence conditions. "What that means, who knows?" New builds Marston’s has build more than 80 new builds in the past six years, including 25 in 2012. Average return on capital since 2009 has been c18%, representing an investment multiple of less than 6x EBITDA. The high return has generated "significant equity value", contributing to the 56% valuation uplift for new builds. Marston’s plans to build between 20 and 25 in 2013, including its first in Scotland, with investments at similar levels. Findlay said it’s "never easy to secure good sites" and but in terms of the potential for locations, "I think there’s still a lot to go at". Marston’s said it has established good relationships with site developers, and it has a "prefered partner" status in many areas. Selection criteria for locations includes high traffic flow and proximity to residential areas, with locations being principally on retail and leisure parks and on main arterial routes to local population centres. Managed: performance Average profit per pub grew 4.1% to £151,000. Like-for-likes were up 2.2% (food: +2.4%, drink: +2.2%) with growth in its three segments: destination food pubs, taverns and premium pubs and bars. "Sales of premium brands performed well complementing the growth of food sales within the estate. Premium cask ale sales increased for the fourth year in succession, with growth in premium lager sales. Wine is an increasingly important category and now accounts for around 20% of our drinks volumes." There was a 0.2% improvement in operating margin through "flexibility in menu management, a continued focus on cost management and modest price increases during the year". Marston’s added: "We have achieved a combination of both sales and margin growth in each of the last three years despite the challenging economic backdrop, a competitive environment and a period of continuous cost inflation." Capital investment included around £60m in new builds and £22m in the existing estate, including the refurbishment of 30 pubs and 14 gardens. Managed: formats Marston’s said its destination food pubs are principally in two fornats: Two for One and Milestone. The sites have a food mix of c55% and include the new builds. Separately, the first three sites are currently being converted to its more independent outlets under its premium phbs and bars division; up to 12 more have been identified if the project is successful. Pitcher and Piano, which fits within the division, "performed well" in 2012, with good growth in like-for-like sales and profit. Food sales mix has increased to around 20% through the introduxction of new menus and a "commitnment to fersshly prepared meals". Marsto n’[s palns to oppen two lodgess in 2013 to be operated under the Marston’s Inns format; currenmtly 50 pubs haver accommodation. Managed: food Marston’s credited its "F-Plan" - a focus on food, families, females and forty-fifty somethings - with rising food sales from 28% of sales in 2005 to 44% in 2012; 28m meals were served in the period, with food-led occasions accounting for 75% of customer visits. "The success of our ‘family friendly’ approach is evident in the three-fold increase in children’s meals sold over seven years, and our commitment is visible in the development of designated family areas within our new-builds and Midas award-winning children’s menus." Marston’s predicted that its share of the casual dining market will continue to icnrease as it invests in new sites. It introduced full table service within its destination food pubs. Other new developments include the introduction of a new customer feedback system, called the SMILE report, and hand-held tills which. This, along with a new kitchen management system, are being rolled out. Marston’s added: "The development of the ‘F-Plan’ is supported by comprehensive recruitment and training programmes designed to ensure that we recruit the best staff available in a highly skilled area, with clear development, training and career paths for all of our pub staff." Tenanted and franchise division Revenue in the division grew 9% to £200.5m, reflecting the increased contribution from Retail Agreements. Underlying operating profit rose 3.2% to £81.8m. Average profit per pub increased by 4.1% to £50,000. Operating margin was 2.3% below last year at 40.8%, "primarily due to franchise agreements". "These agreements generate increased profit but the operating margin percentage is reduced as a consequence of accounting for sales at full retail value." Capital investment in the period was £32 million including around £12 million in Retail Agreement pubs. Retail Agreement Around 500 pubs now operate under the franchise-style Retail Agreement, up from 337 in 2011. Marston’s said that profit growth in sites post-conversion is 23%, with volumes up 13%. Licensee stability is more than 90%. Marston’s receives more applicants for Retail Agreement pubs than tradiotional tenancies, and around 30% are new to the sector. Traditional tenancies Around £7m was invested in the c1,000-strong division in the year, and Marston’s expects this to be "broadly similar" in 2013. Licensee stability remains at over 90%, "maintaining the high level achieved in 2011". Marston’s said it offers "significant flexibility" in agreements, including free-of-tie agreements. Rent increased by 2% in the year and operating margins in the traditional estate were similar to last year. Thompson David Thompson, Marston’s chairman, is to retire after 35 years with the company. Marston’s said: "David’s contribution to the company and the industry has been immense, and his intellect and capacity for hard work have been invaluable. During David’s tenure, as managing director from 1986 to 2001, and as chairman since 2001, the company has expanded from its regional origins to become a national pub operator and brewer. David will continue to demonstrate the passion and enthusiasm for the industry, and for which he is renowned, through his other business interests. He will remain as chairman until his successor is appointed; Robin Hodgson will lead the selection process." Brewing In the brewing arm, total revenue increased by 6.8% to £113.7m. Underlying operating profit increased by 0.6% to £16.4m. Overall ale volumes were up 2% compared to last year, with premium cask ale volumes up 3% and bottled ale volumes up 18%. "We have maintained our market-leading position, increasing our market share in each of these categories by over 1%. In the independent free trade our account base increased by 3% to more than 3,800 customers, and premium ale sales to this sector increased by 3%. In the take home market we continue to perform very strongly with volumes up 14%. Operating margin was down versus last year at 14.4%, reflecting the higher proportion of volume through the off-trade, which commands a lower margin." Fastcask, its cask beer dispense system, now accounts for 30% of cask ale sales, up from 20% in 2011. Current trading and outlook In the eight weeks to 24 November, managed like-for-likes are up 2% (food +3.4%, drinks +0.9%). Tenanted and franchise profits are estimated to be up 3% and own-brewed volumes are "in line with expectations". "We expect market conditions to remain challenging for the foreseeable future, with consumer confidence continuing to be subdued by weak economic conditions. Nevertheless, we are confident that our strategy is appropriate and that our focus on value, service and quality will continue to be attractive to our customers." Financing Marston’s said it plans to diversify its sources of finance over the medium and long term. During the year it entered into a new swap arrangement, replacing the £140m swap that’s due to expire in October 2014. "This new arrangement fixes interest on £120m until 2020. The reduced interest costs resulting from the new arrangement will mitigate the impact of the increase in securitisation interest for the financial years 2013 and 2014." Overall, the group has a £257.5m bank facility to May 2016. The amount drawn down at the year end was £175m. "This facility, together with a long term securitisation of approximately £1bn, provides us with an appropriate level of financing headroom for the medium term, with a structure that continues to provide operational flexibility. The group has significant headroom on both the banking and securitisation covenants. Importantly, the group also has flexibility within the financing structures to transfer pubs between the banking and securitisation groups." Debt Net debt increased £20m to £1,121m at 29 September, due to an increase in CAPEX, and operating cashflow at £168m "remains resilient". "For the period ended 29 September 2012 the ratio of net debt to EBITDA before exceptional items remained stable at 5.6 times (2011: 5.6 times). It remains our intention to reduce this ratio to around 5.0 times, principally through EBITDA growth generated from our new-build investment programme." Net debt to EBITDA at the year end was unchanged at 5.6 times. On a pro forma basis, incorporating the impact of the 2012 new build programme, the figure was 5.4 times. Estate revaluation Marston’s undertook an external estate valuation during the year, which put the overall value of the estate at £2bn, broadly in line with the value in 2011. New builds built since 2009 have been valued at 56% above build costs, and excluding the new builds, the managed estate has increased in value to reflect its "improved quality". The tenanted and franchise sites reduced in value, which represents the current value of tenanted and franchised pubs in the market, Marston’s said. CAPEX CAPEX was £129.8m (2011: £111.5m), including the construction of 25 new-build sites and the development of a further 150 Retail Agreements. Marston’s expects CAPEX to be between £115m and £125m in 2013. Cash return on capital employed increased to 10.7%, "reflecting the continued disciplined allocation of capital within the business". Disposals During the year it generated £48m of cash including £20m from a sale and leaseback transaction, and £28m from the sale of pubs from both the managed and tenanted estate. The firm anticipates that proceeds from disposals will be around £30m-£40m per year for the next few years, with disposals coming from a mixture of traditional and franchised pubs. The majority of disposals are likely to be sold for alternative use. Exceptional items Marston’s incurred net exceptionals after tax of £180.2m, reflecting the impairment of freehold and leasehold properties of £215.1m, a £2.8m write-off of unamortised finance costs relating to its previous bank facility, a net £4.6m charge relating to new swap arrangements and a £3.7m charge which recognises interest charges arising from outstanding tax liabilities relating to unresolved tax issues. Charges were offset by a £2.9m net gain in relation to the value of certain interest rate swaps. There is an exceptional tax credit of £43.1m. Analysts’ reactions Simon French at Panmure Gordon reiterated his Buy recommendation and increased his target price from 130p to 135p. He said: "Marston’s has announced FY 2012A results in line with market expectations, reporting £87.8m PBT (12.3p EPS) compared to ours and consensus expectations of £88.0m PBT (12.3p EPS). The group has declared a 5% increase in the final dividend to 3.9p to bring the full-year payout to 6.1p, in line with expectations. Current trading is robust with LFL sales in the first eight weeks of FY 2013E +2.0% in managed pubs and profit in the non managed estate +3.0% with own brewed volumes in line with expectations. "We do not expect any significant change to consensus expectations of £96.0m PBT (13.2p EPS) for FY 2013E. The stock trades on a CY 2013E adjusted EV/EBITDAR of 8.2x and yields 5.4%. We increase our target price from 130p to 135p – based on a CY 2013E adjusted EV/EBITDAR of 8.5x (P/E 10.0x and yield 5.0%) and reiterate our Buy recommendation." Nick Batram at Peel Hunt said: "The attraction of Marston’s is a straight-forward strategy that is being well executed and delivering growth against a tough backdrop. After a strong run, there may be some short-term consolidation but, with improving cash returns, a 5% yield and the prospects of real dividend growth, we retain our Buy recommendation."