A leading analyst has said that when it comes to returns generated by Marston’s investment in its tenancies investors have to decide whether this cash would have been better invested in the better quality end of the estate, with the bottom end sold off. Geof Collyer at Deutsche Bank said that Marston’s has now had four sets of results in which it has published specific details on the performance of its Retail Agreement estate. Marston’s has stated that the cumulative £30m investment should deliver a 20% EBITA ROI. “In addition to this spend, there is maintenance capex and development capex going into the 1,000 strong Core estate – we estimate around £90m between 2010 and 2014E. We see this as holding the profit line over the next four years, assuming no return on the maintenance capex and 10% on the development spend, whereas if the 20% ROI is achieved, the contribution from the RA estate should rise by around 75%. “It is hard to get the timing right in terms of the ramping up of the RA investments, and we are sure that in the end our forecasts for the margins this year and next year could prove too high in the Core estate and too low in the RA estate. The bulk of the conversions have been in last year and this year and, we understand, the churn in the RA estate on the new agreements has been in the region of 10%, so it hasn’t suited everyone. “We estimate that over the five-year period of the investment plan average EBITA per Core pub should rise by 14%, helped by disposals as well as development, whilst the RA estate should see it rise by 73%, but to not much above £23k per pub. We see the problem here being that our forecast EBITA increase is just £7.2m on £120m of investment. Investors have to decide whether this cash would have been better invested in the better quality end of the estate, with the bottom end sold off.” Can the new build strategy continue to drive retail profits? Collyer said that the group’s new build programme was originally set out in FY’03, with plans to build 20 new pubs a year with average weekly turnover (AWT) that would have been then around 75% higher than the Marston’s retail estate average. He said: “The programme really started in earnest in 2005, but was deliberately moth-balled towards the end of 2008 due to the recession and maybe a cash flow squeeze that came with it. It was an established success story before being stalled. We estimate that 60 new pubs had been built prior to the programme being extended to include an additional 60 from 2009, which were to be even bigger than the earlier models. There are plans to extend the programme by another 75 new builds by end FY’15, though some of these will be smaller – hence our view that investors should look at the entire programme, not just the post 2009 versions.” By end FY’14E, Collyer estimate that the group will have built 174 new pubs over ten years, representing around 30% of average pubs trading and generating almost 60% of the managed estate EBITDA, or around 25% of the group’s pre-central overhead EBITDA. He said: “By end FY’14, we estimate that the new build programme will have propelled the Retail division’s share of group pre-overhead EBITA from 38% in FY’07 to 47%, (and vs. 51% in FY’01). The overall plan is effectively delivering an attractive EBITDA return on the new capital. Our only concern with this plan is that maybe too much attention and capital is being devoted to the newer pubs and not enough on the other 70% of the retail estate.” Can the dividend grow? As part of the 2009 rights issue plan, Marston’s rebased the dividend to a level from which it could rebuild cover to 2.0x. Collyer said: “Having reached this point in H1’12, the dividend was increased by 5%. We have argued that determining dividend paying capabilities by analysing free cash flow after maintenance capex is not conservative enough. We believe that the definition should be refined further to reflect free cash flow after all capex on the existing estate and after servicing amortisation of securitised bonds. This is because the amortisation schedule is a long-term legal commitment, and should be funded from operating cash flows. If the group was to adopt this definition, then the ability to grow the dividend would be constrained until FY’14E, based on our estimates. Can the cash flow support the investment programme? Collyer forecasts “a busy capex programme” for the group between FY’12E - FY’14E: (i) £145m of maintenance and development capex, and (ii) £176m on new builds. He said: “We estimate that free cash flow generation after funding the securitisation amortisation (£65m) and development capex (£75m) but not the new builds should provide £95m, with disposals chipping in an additional £75m. Our cumulative forecast dividend payments over this period are £110m. “During H1’12, the group rolled it bank facility until May 2016, providing it with around £300m of financial resource. This was £161m drawn down at the H1’12 stage. After all of the above outflows and inflows, we are forecasting a net £117m increase in borrowings by end FY’14E. With £139m left undrawn in the bank facility, there should (just) be enough to cover the investment plans. “The group target is to reduce the net debt / EBITDA gearing through growing EBITDA as opposed to repaying debt. We are forecasting this metric to fall from 5.8x at the end of FY’11 to 5.3x by end FY’14E.” Valuation & Risk Collyer values Marston’s on 11.25x forward EBITA, taking into account not just the strong asset base but also the point that half of the profits come from the more lowly rated tenanted and leased pub division. He said: “On the upside, (i) an unexpected acceleration in like-for-like sales, driven by a better-than-forecast performance from recent pub acquisitions; (ii) much better performance from the Retail Agreement strategic initiative in the tenanted estate; (iii) a step-up in the new build managed pub opening programme. “Downside risks: Operational, notably a failure to extract the savings expected from acquisitions and transfers to tenancy; a greater-than-expected impact from the smoking ban and the deteriorating UK economy; further erosion of margins in the retail and brewing divisions beyond that already factored in; a material step-up in tenant support levels; and a collapse in the eating market caused by recession. “On top of that, a failure to invest the proceeds of the rights at the expected speed, since we see that as the prime generator of growth in the business going forward.”