Collyer sets out Punch’s options

Geof Collyer, leading city analyst at Deutsche Bank, looks at the options for Punch Taverns, which is set to announce the results of its strategic review on 22nd March. Background We discussed in our “A driver or a passenger” note of November 2010 the need for Punch to focus on improving the quality of profits in both of its divisions. We know, because of the disclosure by the group, that Punch is injecting cash held at the PLC level into the Punch A & B securitisation structures. It was £28m in FY’10 and is forecast by the group to be around £45m in FY’11E. The cash injection is not in the numbers as reported by Punch at its group year end, but it does show in the bond holder documents the margin movements that are being supported and the scale of cash required to prevent A & B from defaulting – an estimated 15% of A & B’s EBITDA in FY’11E. We know that some of this cash is recovered by Punch being able to upstream cash for tax purposes from the securitisations. (Tax planning has been something of a group speciality and again in FY’11E there does not appear to be any cash tax payable). At some point this position will reverse, and the upstreamed cash could be needed to actually pay corporation tax. In the context of the group P&L, this cash support for A & B is equivalent to roughly half of the group’s post tax profits and it is likely to be required for some time to come. The final results slides showed £317m of group cash plus £114m of securitised bonds held at the plc at the end of August 2010. There was £52m of cash in Punch A, £37m in B and £33 in Spirit Issuer. These are broadly required to sustain the securitisations in the event of trading cash flow difficulties and can’t really be counted as plc cash flows. The £114m was the nominal value of debt bought by Punch in the markets or by tender and we would expect it to be sold into the securitisations for the market price it was bought for. We estimate that Punch Taverns plc would have access to around £300m of cash to either support Punch A & B or to invest in its managed estate. As discussed above, Punch is injecting a lot of cash into keeping the two pure tenanted pub securitisations A & B from either dropping to a stage whereby the group has to call in consultants, which would effectively see the bond structures taken over by the bondholders, or even lower, defaulting which would result in the same situation. Things are seldom straightforward in any restructuring process and even if Punch A or B defaulted, there is no hair trigger that would cause events that should happen, to happen quickly. According to slide 15 of the final results presentation, at the end of August 2010, Punch A’s DSCR was running at 1.41x and Punch B’s at 1.48x. Both of these were below the cash trap level – the point below which Punch cannot upstream any cash to the plc apart from paying tax. Stripping out the cash support (see above), these fell to 1.33x and 1.11x respectively. This is just above the default level of 1.25x in A and below the default level of 1.25x in B. This position is likely to have deteriorated since August 2010 as like-for-like profits are still declining – we estimate by around -5% to -6% in FY’11E. Although both of these DSCRs are very poor, there remains good headroom in the net worth covenant (£220m for A and £196m for B) though this suggests that there are no more asset downgrades expected. There may never be much if any value in Punch B and never much intention to upstream any significant sums of cash, but there would be a reasonable amount in Punch A but for the June 2006 refinancing. This saw Punch A saddled with almost £400m of additional debt. This comprises most of the £527m of net exceptional costs generated by Punch over the past decade. We estimate that but for this, Punch A’s post interest cash flows would be almost 40% higher, and it would be out of cash trap. Not much one can do about that now, and it is back-jobbing, but it does suggest that Punch’s PubCo business model is not structurally flawed, but suffering from previous management’s failed M&A strategy on buying Spirit in 2005. In addition to the securitisation support, the managed estate has been supported as well – and this time directly through the P&L. In the last two years, around 25% of the reported managed pub profits have been accounted for by onerous lease provision release. We know from the Spirit Issuer documents that the reported profits for the managed estate are broadly equal to those generated by the 82% of the group’s managed pubs that are held inside the Spirit Issuer structure, implying that the other 18% held outside are losing £14m a year, or would be, but for the provision release. The worrying thing for Ian Dyson, the new CEO, is that, without the tax losses keeping cash tax payable at bay and allowing cash upstreaming to offset the support for A & B, the combination of the cash injections in the tenanted and leased securitisations and the losses incurred in the managed estate could burn through the approximate £300m of cash and near cash held at the plc level in just five years. Strategic review The strategy review is due sometime before the end of March, though it wouldn’t surprise us if it slipped into April, given the complexities involved. Punch and its advisors will be working through the various options of what to do with the businesses. We believe that Ian Dyson needs to establish a base from which Punch Taverns can grow as an equity-based business. This is his first CEO role, and we would not expect, and do not expect, his strategic review to come up with a response that would result in an instant turnaround for the group’s fortunes – they are too complicated for that to be a possibility. We think it would make sense for the CEO to give himself a three-year turnaround timeframe. A number of suggestions as to what might be proposed have been bandied around the market since the decision to conduct a strategic review was announced back in November 2010. The trouble is that it is hard to see how any of them result in a positive view of the current value of the equity at this point in time. Because of the possibilities of bond default and need for significant restructuring, we would expect that the bondholders have now got advisors for themselves as well, either individually, as bond classes or for each of the entire securitisation structures. To date, the only actual appointments that we are aware of are those of Rothschild and Latham Watkins for the Association of British Insurers (institutional par bondholders) and FTI Consulting for Ambac UK, the monoline insurer, who, along with MBIA, are the credit wrappers for many of the securitisation’s tranches of debt. The fundamental problem with dealing with bondholders is that, unlike the equity market, some are definitely more equal than others (there are many different levels of risk in a securitisation), and if there is going to be a debt-for-equity swap proposed in any part of the strategic review, then the junior classes of debt are possibly going to get little if any value for their investments. At current levels of profitability, we do not see any value in the equity at this stage of the economic recovery. So what could be done to change this position? We are not in much of a position to judge how the bond markets will react to these issues; we do not see many of the possibilities as being much more than helpful, but not necessarily solving the fundamental problems of the securitisations’ indebtedness and dull current trading. + Covenants could be reset, allowing lower levels of DSCR before hitting default. This could provide some breathing space to enable operating management to try and rebuild the trading performance. + Deferral of the amortisation schedule to allow for a rebuilding of profitability in A and / or B. Although this kind of repayment holiday is common for domestic mortgages, it is rare in securitisations, due to the care that goes into protecting bondholders’ interests when the structures are set up. + Tweak some of the bondholder documentation, allowing greater freedom to dispose of pubs without value restrictions. + Allow repayments of whichever debt classes that Punch management sees fit, as opposed to having to follow a strict waterfall arrangement. This might enable Punch to repay some of the more expensive debt first, though some of this may be junior tranches of debt that are low down in the repayment pecking order. + Allow Punch B to default – it is effectively in default now without the cash injection from the plc - since it is unlikely to generate any meaningful cash for upstreaming now that it is amortising. This would maybe allow for lower levels of cash injection to get Punch A back on its feet. We believe that the problems of the PubCo model are structural for the bottom end of their estates but cyclical for the vast majority of pubs. + Economic recovery can play an important part in helping to rehabilitate Punch A, even though its arrival is somewhat out of the control of the strategic review. + Split Punch Taverns into a Good PubCo, with the managed-to-lease conversions and the managed pub estate moving into the Good PubCo, and a Bad PubCo. Offer a debt-for-equity swap to some or all of the holders of the junior classes of bonds. This is likely to receive some real consideration, but will probably go down badly with those who invested at 100p in the summer 2009 equity placings that delivered 50% EPS dilution to existing holders, since it would imply even more dilution. + This could be seen as sort of demerger, although we suspect that it may even be possible, as the securitisations are separate legal entities, to offer debt-for-equity swaps in the individual securitisations directly. + The owners of this Bad PubCo might decide to dump their holdings in the market to get anything back for their troubles. + Marking to market some of this debt – an effective reduction in the principal – might make this option more palatable to some equity shareholders. + Walk away and hand both Punch A & B back to the debt markets and reinvest the cash held at the plc level into the managed pub division. + It is not clear under any handing back scenario whether Punch would be offered a management contract by the bondholders to continue to run the assets or whether third parties like Enterprise Inns, Admiral Taverns, Marston’s or S&N PE would be asked to run them for a management fee. + Under a total walk-away scenario (see the bit on pre-packs below), it is not out of the question for Punch to buy some or all of the pubs back from a collaboration of senior bondholders – and this may well be a preferred option for many in the debt markets who just don’t want to be left holding a load of pubs that they don’t know how to run. It may also be a way of squeezing out some of the junior tranche holders. (As a general rule, when looking at securitisation documents. The higher up the alphabet, the more senior the notes.) + Continue with ‘Plan A’, supporting the securitisation structures with cash held at plc level, and continue to work on the restructuring of the estate by introducing the new lease agreements, selling off the bottom end sites, and paying down debt. This could be seen as a ‘do-nothing’ option and could burn through all the cash held at the plc level without solving the underperforming trading problems. + However, one of the problems of handing A & B back to the debt markets is that when the debt is repaid – it may be a big ‘if’, not ‘when’ – then the bondholders will have a free option on the real estate and operating profits of £3.4bn worth of pubs. We could go on…there are bound to be many permutations and we have no idea – and we are not sure Punch has either – as to how many vested interests are likely to be involved in any discussions. Whichever course is taken, the Punch management team will be trying to ensure that the major drinks suppliers do not see any restructuring as a ‘change of control’ clause and seek to renegotiate supply terms that could erode the operating margins of the businesses being retained – especially since we believe that the Punch managed pub division has the highest gross wet margins amongst the major managed estates. For us, trying to protect the shareholders’ options over the eventual equity value that should pertain once the debt is paid down should be crucial, though we can see the attractions of just cutting A & B loose from a pragmatic point of view and starting again with a smaller business that could grow, though it may not result in the shares going up for a while after the event. What is left if this happens? Spirit Issuer is the third securitisation. It is a mixed managed and leased business, comprising 82% of the managed pub division (the predominantly profitable pubs) plus a number of managed–to-lease conversions that make up about 10% of the group’s tenanted and leased estate. We estimate the historic house EBITDA at £166m (£130.9m plus £35.1m of overheads), implying an August 2010 multiple of 9.7x or a 10.3% cash yield on tangible fixed assets. At the end of FY’10, there were a further 145 managed and 78 tenanted pubs held at the plc level. The attraction of getting rid of A & B is that the £300m of cash held at the plc level within Punch Taverns can then be invested to grow the remaining managed pub business, with the rump lease business providing additional cash flows to also invest or pay down debt. We estimate the pre-investment fixed charge cover at 1.48x compared with our FY’11E for Punch Taverns today at 1.44x, (which includes the benefit of the onerous lease provision), although post the investment we estimate this to rise to 1.85x (excluding the benefit of the onerous lease provision). The New Punch business would have almost £700m of off-balance sheet debt (annual operating rents of £69.5m capitalised at 10x). This will mean that New Punch will have the highest level of off balance sheet debt in the pub sector. As we approach the adoption of the new accounting treatments for leases, due to be finalised this year, this off-balance sheet debt will be brought onto the balance sheet, and fixed charge cover (FCC), as a result, should become a more widely used metric for assessing a company’s financial health. We are currently forecasting FCC for the other pub stocks in a range of 1.8x to 2.4x for FY’11E, and we estimate that New Punch would move into this range as opposed to being dangerously below at present. Given the estate freehold / leasehold mix, we see a multiple somewhere between JD Wetherspoon and M&B as being more appropriate for New Punch – around 7.5x EBITDA. This is perhaps a touch generous as it gives the benefits of what would likely be a three-year investment programme upfront and does not really take into account the inferior fixed charge cover of New Punch – we estimate M&B FCC is 2x and Wetherspoon at 1.8x. Based on this scenario, we struggle to see any upside from the current Punch Taverns share price for New Punch. However, this analysis does not take into consideration any negative impact on the valuation from the onerous lease provision. We estimate that around 350 of the managed pubs are run on operating leases and about 190 of the leased conversions are effectively sub-let to either small multiples or sole trading tenants. Furthermore, we understand that some 180 managed pubs (over 20% of the estate) are loss-making and their profitability set to zero each year by the utilisation of the onerous lease provision, which was increased to around £85m last year. On top of which, there are another possible 100 pub that could return to Spirit / Punch through the reversionary lease process – queue a contingent liability? We estimate that Punch will burn through this provision within six years at the current rate of release, yet we understand that the average lease length for those sites affected to be about eleven to twelve years. When Bass and Allied Domecq sold their brewing businesses in the 1990s, the supply agreements to the retained tied estates were set in favour of the new brewing owners. This penalised the pub estates’ profitability for the duration of the contracts. The Bass managed business – now Mitchells & Butlers – took the costs on the chin, but subsequently benefited when the contracts were renegotiated, while the Allied retail business, much of which went to Punch Taverns, established an onerous contract provision that amortised through Punch’s cash flow statement for ten years, effectively flattering the Punch Tavern’ PBT by around £8m per annum. The accounting treatment for onerous contracts or onerous leases is not obligatory but it is allowable, enabling companies to disguise the true cost of doing business through the reported Profit & Loss Account, though obviously the cash cost has to be taken through the cash flow statement. The establishment of an onerous lease provision – Marston’s has set one up as well for poorly performing leases in its managed estate, so Punch is not alone – is materially flattering the Punch managed estate profitability, overstating the last two years’ reported EBITA by 22%, or £25.7m. If Punch is ‘starting again’, then the proper profit base for the managed estate has to be the base from which to move on from, not one that is artificially inflated. We believe that any bidder for the managed business would multiply the annual provision release by the years left on the lease and deduct that from any price paid for the business. Average of last two years provision release (£13m per annum) multiplied by average twelve years equals £156m, or roughly a negative 24p per share on any valuation. So can New Punch get rid of these leases? It has been common practice amongst private equity-owned managed pub businesses in recent years that have struggled against the negative impact of operational gearing working in reverse (rents going up, sales going down) to seek a pre-pack administration structure or a company voluntary arrangement (CVA). Pre-packs seem to have been the chosen area by the pub sector of avoiding huge business problems and in some cases legal threats by selling businesses on to third parties – a ‘new co’ – or even to the existing directors. In the case of Novus, Admiral Taverns and Barracuda, they were more debt-for-equity swaps with the banks being fully supportive of existing managements and not requiring any forced disposals – to our knowledge. The companies in the table are almost exclusively managed pub businesses (Admiral being the main exception) that have suffered from negative operational gearing or where private equity owners have saddled the operating business with excessive debt, either through paying too much in the first place for the business or through refinancing out their original equity investment by overloading the operating business with unrealistic levels of debt. It has not been uncommon – because private equity tends to look at EBITDA or EBITDAR multiples when valuing businesses – for the headline valuations to take little account of either the need to pay the interest bill or to reinvest in the business. When Punch bought Spirit, this was part of the problem – the cost structure was more that of a privately owned business rather than a publicly owned one, and a reasonable proportion of the increase in the cost base was down to the ex-FD, Phil Dutton, trying to establish a proper cost base for the business going forward. Can New Punch pre-pack up its troubles? As we hinted at earlier, it is not impossible that Punch decides to do a pre-pack, and take the business private, as part of a plan to play hardball with the debt markets away from the prying eyes of the equity markets. Or it could seek to use this system to get rid of the troublesome operating leases. So is it possible for Punch to act now like a private equity-owned business and effect some form of pre-pack on the onerous leases within the estate and cast them adrift, thereby removing the £14.8m of annual losses currently being incurred? In many of the above cases of companies going into administration, the victims were small private landlords who had their properties handed back because of the change of ownership being wrought by the pre-pack process. Punch should know how they felt as it was a major victim, having had 82 pubs (64 managed, 10 tenancies) revert to its management because of the pre-pack or administration process or individual bankruptcies over the past two years. Punch could go back and renegotiate with the landlords. According to other pub groups, these seem to be more amenable to a deal if there are only a couple of years left to go on the lease. Otherwise, it is just tough. We have not seen many examples of publicly quoted companies going into pre-pack – it is rather frowned upon. However, we would expect that the Punch’s board will be watching closely the current attempts by JJB Sports to try to renegotiate the leases on around one-third of its shops. According to the Sunday Telegraph (13 February 2011), this will be the second time in two years that JJB has tried to do this. Last time property owners backed its CVA. This time, according the Telegraph, JJB is likely to find its landlords, including British Land, Hammerson and Prudential, less willing to play ball, as landlords would fear the floodgates opening with every retailer in the country trying to reduce its rent. Notwithstanding the severity of the recent recession, we would have thought that, when signing a 25 year standard commercial upward only lease, that one would recognise that the period would encompass several economic cycles, and so the lessee should be prepared to see periods when profitability would be squeezed. And in this situation, Punch is not in danger of its retail business going into administration, so its bargaining position may not be as strong as a really weak company. Punch’s problems on the onerous lease front stem primarily from two sale and leaseback transactions that Spirit undertook in 2004 to partially refinance its 2003 acquisition of Scottish & Newcastle Retail, but prior to Spirit’s eventual sale to Punch Taverns in December 2005. So far from being able to squeeze small landlords, Punch has to deal with just two – Prestbury (220 pubs in a £500m sale & leaseback deal) and British Land (65 pubs in a £174m sale and leaseback deal). So it is with both of those groups that Punch will have to renegotiate hard to sort out or alleviate the current problem. The tangible fixed assets for Spirit Issuer were £1.61bn. These are the assets along with the loss-making pubs held at the plc that will be in New Punch. So where does that leave the balance sheet and P&L for the rump business? We have adjusted our P&L to add-back the onerous lease provision release benefit, so have removed the onerous lease provision from the balance sheet; i.e. we have reduced the EBITDA by £15m. We have assumed that the £300m of cash held at the plc is fully available for investing, and again we have given the proforma P&L the full benefit now in terms of additional profit and a full 15% EBITDA return on the incremental investment for a programme that will probably take three years to complete, and not allowed for any cash costs of any forthcoming restructuring, fees, swap break costs, etc., to eat into the cash potential pile to invest. Even though things have improved operationally since the new MD took over in the Punch managed business two years ago, the EBITA has still fallen by around 40%, adjusting for 5% fewer pubs but stripping out the onerous lease provision releases in FY’09 and FY’10. We have ignored the drop in depreciation charge, resulting from a 20% write-down of the managed estate assets over the same time period, which resulted in a £7m benefit to the EBITA line in FY’10 – this would have made the EBITA fall even worse. What we are driving at here, and it may appear a bit callous given new management, is that we do not see why New Punch should be given the benefit of the doubt in terms of where profits might get to, given its generally woeful track record over the past ten years. In our view, New Punch would need to earn the right to trade at a peer group multiple through consistent improved performance. We would argue that we are giving some benefit of the doubt, since the FY’11E EBITA multiple without the benefit of investing the cash would struggle to have a positive equity value. Downgrade from Buy to Sell – it may be a high risk recommendation Restructuring could take a long time. It is a complicated process and some (according to Debtwire, 7 Feb 2011) think it is the most complicated debt restructuring since Eurotunnel, which took many years to resolve. It may take several years to determine what New Punch will look like, or if the restructuring will eventually create more value than the current share price suggests. In the case of Spirit, the market was asked to effectively wait for three years to see if the acquisition and subsequent restructuring generated any value. We don’t think it did. As we have said, we believe that most of Punch’s problems stem from that deal, which generated woeful ROI. If equity investors are going to be asked to sustain another long wait, to see if value is going to be created from whatever is going to be proposed in the strategic review, after enduring the fall in the share price not just since the stock peak, but more realistically since the 140% increase in equity at 100p from the June 2009 placings, then not everyone will hang around. Because of the uncertainties surrounding the strategic review, our current view that there is little if any equity value at present in either of the two tenanted securitisations, and our view of where a standalone New Punch would trade if it was the remaining part of the equity investment, we have dropped our DCF-based price target generating methodology, and reverted to one based on an EV / EBITA multiple. It also seems a little pointless using a cash flow based valuation methodology for a group where is unclear whether the equity shareholders can gain access to the any of the cash in the short to medium term – or indeed just what that cash will be. Therefore we have reduced our target price from 95p to 55p and, as a consequence, we are downgrading our recommendation from Hold to Sell. It may be a high risk recommendation change, given the proximity to the publication of the strategic review, but from here, it is difficult to see a clear equity story emerging in the near term – which is not to say that one will not emerge. Going back to where we started earlier in this section, we would assume that Ian Dyson has set himself a three year target to sort Punch out. This may therefore involve the share price falling before it goes up. The other risk to our bear case is that someone bids for New Punch – but why would a bidder pay for all of the benefits of an acquisition to Punch’s shareholders? And they would certainly adjust the EBITA to reflect the underlying lease cost. In many ways, the brave decision might be to do nothing and let the current process of supporting Punch A & B take its course. That though seems a little unlikely.