A leading analyst has questioned whether Spirit’s annual reinvestment is sustainable vs. the peer group and warned that if the pace of like-for-like growth falters, the operational gearing of the business – the highest in the sector – could put pressure on group profits. Geof Collyer at Deutsche Bank said: “Spirit has laid out its expected levels of reinvestment in its business from FY’13E onwards. Following a period of catch-up capex, the new deemed-to-be-sustainable levels of annual reinvestment are now meaningfully lower than the peer group – even lower than the pure OpCos of Tragus and Gondola, which as restaurant businesses have lower levels of wear and tear than pubs, and around 200 bps lower than when Spirit was run by private equity. “This should make Spirit even more dependent upon lfls growth to drive the business forward. So if the pace of lfls growth falter, the operational gearing of the group – the highest in the sector – could put pressure on group profits.” Collyer also asks what is the company real peer group? He said: “Ever since demerger, Spirit has been seen as a managed retail pub group yet its business and profit split is much closer to Greene King and Marston’s than to either JD Wetherspoon or Mitchells & Butlers, who are the sector’s biggest pub retailers. “It is the fourth biggest managed pub business revenue and estate size, and fifth biggest in profit terms, after excluding the provision utilisation. Greene King, M&B and Marston’s managed estates are all comfortably over 90% freehold, whereas Wetherspoon is 60% leasehold compared to around 45% at Spirit. This property tenure split is important since leasehold estates have generally been valued by the market at a lower multiple compared to the freehold ones. Currently, with the second highest component of operating leases in its business mix, Spirit is trading at between a 17% to 28% EV/EBITA premium to the other pub groups that have retail businesses.” Can the tenanted estate be turned around? Collyer said that Spirit’s plans for its tenanted & leased estate have changed since demerger and are now based on (i) selling off around 80-100 sites; (ii) reverse transferring around 100 pubs back into management – though this is taking significantly longer than expected; and (iii) converting around 200 of the pubs into some form of franchise, where the group can take a more direct control of the retail offer. He said: “We see this latter approach as being more comparable to the Greene King Meet & Eat franchise as opposed to the Marston’s Retail Agreement version. We scaled back our reverse transfer forecasts to just 10 a year from 25, and we understand that the level of original disposals planned have also been scaled back. Apart from taking greater operational control, few details of the new plan have been published – October 2012 could provide further information. But what we do know is that turning around an underperforming T&L estate is not easy and can take years and will cost money – just ask the peers. “Spirit’s T&L estate performance is still going backwards, and is likely to remain a brake on performance of the overall group for some time. Maybe optimistically, we can see the profits stabilising within three years. We are forecasting T&L EBITA to be down by 9% this year and by 10% in FY’13E and -6% in FY’14E.” Is the dividend sustainable? Collyer said: “Given that they are mandatory and need to be financed from operating cash flows before development spend, we think that a more conservative definition of dividend cover should be based on free cash flows after securitisation bond amortisation. The most surprising news on demerger last year was the plan to start paying a dividend from H1'12. “Following the near halving of maintenance capex from £27m last year to around £15-16m, this payment is now which looks to be covered by operating cash flows after investment in the existing estate. However, we see this as a temporary position, unless the operating performance really steps up, since bond amortisation (of £23m) kicks in from FY’14E and could send the dividend back into uncovered territory. Valuation & Risk Collyer value’s Spirit Pub Co on an 11x EV / EBITA multiple for the year to August 2013, which he said reflects a half way house between the pub groups that are more geared to operating leases in the sector and those that are asset rich. He said: “The Spirit asset mix is one third operating leases at group level, but 45% in the managed estate, of which around one-third are loss making. Around 40% of EBITA comes from more lowly rated tenanted and leased pubs; and because of the distorting impact of provisions in the P&L, we believe that Spirit should trade at a discount to the more freehold-based managed group peers. “In our calculation, we exclude the provision credits that inflate the reported P&L, and include the pension deficit funding in our net debt. The upside risks to our Hold stance include: (i) maintaining the material lfl sales performance, but in the face of tough comps. (ii) A bid for either division in what is still a consolidating market. “Downside risks include a failure to turn around the underperforming tenanted and leased estate, creating further pressure on the retail performance. (ii) Failure to sort out the reversionary leases, which could lead to an increase in provisioning, thereby potentially undermining management credibility.”