A leading analyst has suggested that Spirit Pub Company needs to bulk up to improve its cash flows and balance sheet, and that a nil premium merger with Stonegate could prove an interesting solution. Geof Collyer at Deutsche Bank thinks that Spirit would benefit from bulking up in terms of both profits and market capitalisation, to bring itself onto a wider base of investors’ radar screens. As with M&B and Greene King, we think that the needs of both parties could be settled without the need for any cash changing hands. This could be an extreme underestimation, especially where private equity is concerned. “However, we think TDR could be playing a long game, and because it used equity (it’s own cash) not debt (someone else’s cash) to buy the M&B pubs and because the T&C deal was a merger without any cash seemingly changing hands, we think that a second deal without paying out any cash could appeal – especially if it provided a longer term way out of its investment, or gave it acquisition currency in the form of quoted equity to continue its plans for consolidating the pub space. In note entitled Spirit Gate, Collyer looked at two versions of the new capital structure and multiples, one which is based on the equity bases – (A) 49% Spirit / 51% Stonegate, and (B) where the new enlarged equity is based on share of implied PBT, with Spirit 58% and Stonegate 42%. He said: “In (A), we do mid-single digit earnings enhancement, whereas in (B) we see this up around 20%. Given that JD Wetherspoon is trading on 10.1x for FY’13E, we would argue that Spirit-Gate (A) looks right, especially since the freehold / leasehold asset mix is broadly comparable. Spirit’s exposure to its underperforming T&L estate reduces under both scenarios from around one-third of pre-provision EBITA to under one-quarter, which would help the rating. “Spirit might argue that, as its profits are higher, (B) would be more appropriate, but what Stonegate would bring would be a balance sheet with little debt. We estimate that the net lease-adjusted debt / EBITDAR ratio was 3.6x on merger, compared to more than 7x for Spirit for FY’13E.” Collyer said that in his view there is certainly no scope for any cash sweeteners for this merger, with securitisation bond amortisation starting in 2014 – a point at which he thinsk Spirit’s dividend will be uncovered by operating cash flows after investment in the existing estate and after funding bond amortisation. He said: “This latter point is important, given Spirit’s need to refinance some of its debt in the near future. Having a less stressed cash flow and balance sheet would put the group in a far better light with the bond markets. We can see the attractions of a possible merger for TDR and for Stonegate, given its drive to be a consolidator.” Collyer said that although the maths of a possible deal looked compelling it may niot be so for the Spirit management team. He said: “Since taking over, Mike Tye and team have been moving Spirit ever closer to a pub business driven more by food than drink, so tying up with a more wet-let business like Stonegate may not appeal in the slightest. It could be seen as undoing a lot of the work already undertaken not just by the current management team but by some of the previous generation, which sold a lot of pubs that they thought unsuitable to the modern consumer. “However, at least Stonegate has had the opportunity to hand back a number of pubs to landlords that didn’t fit when it carried out its controlled administration back in 2008. Even though these are difficult things to admire, at least Laurel Pub Co – as it then was – paid off all of its bills, which is quite rare under these circumstances. So there shouldn’t be a tail of pubs coming back to haunt Spirit as a new owner / partner, unlike its own unfortunate experience.” Collyer said that Spirit may have its own M&A list of targets, both wish list and hopefuls, and Stonegate may not be on it. He said: “If it had a better balance sheet, we think that Spirit would fancy itself as a good option to buy the Whitbread Restaurants – where Mike Tye used to work (MD Costa, MD Premier Travel Inn, MD David Lloyd Leisure) – so improving the balance sheet in preparation for such a possibility could very well appeal. “We think a potential deal with Stonegate could prove to be an interesting step, or would the Spirit management team see it as a retrograde move given that a lot of the work put in over the past few years has been reorienting the group towards a more food-led future. We think that Spirit’s investors would approve of a stronger balance sheet, and bulking up the business could provide not just better longer-term growth opportunities and a safer dividend but a much more secure and less operationally geared business, which should therefore flow into the multiple at some future stage. “We doubt that Spirit is NOT on the Stonegate wish list. Pubs are in the DNA, especially since one the directors of TDR was one of the private equity players who helped buy the original Bass Lease sites that formed the origins of Punch Taverns back in 1998. And the Stonegate chairman has a long history in the sector going back to Guinness in 1978, through MD of Bass Lease, Commercial Director of Bass Taverns (now M&B), CEO Laurel Pub Co, via Stakis casinos and Gala Bingo.”