JD Wetherspoon (JDW) needs to try and re-establish the link between like-for-like sales growth and profits’ growth, which in turn should place less stress on the rollout programme as the primary driver for growth, according to Geof Collyer, analyst at Deutsche Bank. Collyer said that unless this happened “one could be forgiven for believing that increasing scale is required to offset costs that cannot be contained”. He said: “As a prelude to renegotiating all of its debt in FY’10, JDW had managed to stabilise its up-until-then highly volatile operating margins. Having got them to 10%, management’s view was that there was no reason why the group should have any H1/H2 volatility in its margin. “Unfortunately, the stability only seems to have lasted for that first year (FY’10). Over the past decade, we estimate that the group’s purchasing skills and changing mix have managed to improve the gross margin by just over100 bps, so it the actions below this line that have caused the pain. Over this period, Wetherspoon has struggled not just with movement in the annual operating margin but also with the intra year margin. “Sometimes this will be a timing issue; e.g. beer excise duty goes up in its third quarter; the UK National Minimum Wage goes up in October each year, which is the end of the group’s first quarter; or it has been the timing of new utility contracts that have also tended to kick in around the September/October time. But a lot of the variation has been the shifting patterns of marketing initiatives, which have been used to drive sales as the main weapon to cover costs pressures. “In recent years, the group has reduced the annual swing on margins into a relatively narrower range, (from a historical perspective), but with cost pressures all round at the moment and volumes under pressure, the temptation to offset these with more aggressive marketing could increase volatility in both margins and hence cash flows and profits. Even though the group’s management tends to focus more on cash flows than accounting margins, investors and the banks that have financed the group do like to see some sense of stabilisation here. Can sales growth be re-linked to profits growth? Collyer said that JDW and Greene King have both significantly increased the scale of their retail businesses over the past decade (FY’02 – FY’12E), compared to the managed pub peer group. He said: “JDW’s total pubs have increased by 53% whilst GK’s have gone up by 67%. However, average sales per pub have grown by a compound +2.7% per annum with average EBITA at -0.1%, compared to GK’s +4.6% and +6.1% respectively. Almost all of JDW’s have been new builds, whereas at GK, they have been a mixture of new builds and conversions, but mostly single site acquisitions and M&A, which invariably includes a number of sites that you would not choose on a standalone basis. “Despite JDW handpicking all of its sites, the trend over the past decade for its lfl profits does not look a good one, delivering declines in seven years out of the last nine, and with FY’12E set to make it eight out of ten. This might imply that the average quality of pubs built has deteriorated.” Collyer said that cost pressures have impacted JDW harder than most of the other major managed pub estates, due to its greater operational gearing. He said: “We think that the group needs to try and re-establish the link between lfl sales growth and profits’growth, which in turn should place less stress on the rollout programme as the primary driver for growth. Otherwise one could be forgiven for believing that increasing scale is required to offset costs that cannot be contained.” The rollout programme has been a cash drain… Collyer said that in recent years’ the company’s rollout programme has been the principal driver of any operating profit growth, but it has led to a cash outflow of over £100m (excluding the VAT rebate) over the past three years alone and has meant that the group had to go back and renegotiate its banking facility and extend it barely two years after it was signed. He said: “The group has been outspending operating cash flows on the rollout programme, compounding the cash outflow through share buybacks that have accounted for almost 70% of the overspend, and which have been funded out of borrowings. So the decision to halve the opening programme from next year has been broadly welcomed by the market, especially since it should return the group to being a net cash generator.” …so now it’s been cut, what will happen to the cash flows? JDW passed its dividend in H2’08 and FY’09. At the H1’10 stage, the group not only reinstated its dividend but paid out a special of 7p by way of compensation to those who had missed out. Collyer said: “Since then, the dividend has been held at 12p a year. However, with the rollout now dramatically reduced, the cash flow profile of the group is much better. Given the relative lack of growth at the group – one of the reasons why the estate plans have been slowed – the net free cash flow is now positive, providing more scope to reward shareholders. “The chance to actually receive the surplus cash flow that has been generated operationally should be something that should find favour with most shareholders. If the group gave back all of the net free cash flow in FY’13E – FY’15E, we would raising our dividend forecasts by 39%, 86% and 127%. This would bring the payout ratio down from our forecast 3.3x this year to 2x over the next three years, implying a dividend yield at today’s price of 3.6% (FY’13E) rising to 5.9% (by FY’15E). It won’t happen quite as dramatically as this, since the group has to refinance its debt all over again by March 2016, but there is significant scope to up the payout.” Valuation and risks Collyer said he valued JDW on a 10x FY’13E EBITA multiple, with the implied value underwritten at the same level by his DCF model. He said: “This is around a 10-15% discount to the multiples we use for the other managed pub retailers. We think this is appropriate given: (i) JDW's long run of lfl profit declines – FY’12E is looking like the eight year out of the past ten when lfl profits will fall; and (ii) because its pub estate is predominantly leasehold tenure and should be valued at a lower multiple than the predominantly freehold asset bases of its major peers Greene King and M&B. “Risks to our stance include: This is an operationally geared business, and so small changes to top-line outlook can have a material impact on profitability - a 1% change to our FY’13E revenue assumptions would have an 8% impact on pre-tax profits. As such the key risk to both the downside and upside is how trading evolves in relation to the UK consumer.”