Greene King still has plenty of scope for more small pub company deals and has both the operational skills and the balance sheet to invest and drive home significant market share gains in the eating out market, according to leading analysis Geof Collyer of Deutsche Bank. Collyer also said that he expected the five-year strategic evolution plan that the group laid out in June 2010, which was to focus more on the controllable parts of the business – retail and brewing – and reduce the less controllable parts – tenancies & leases, to reshape the profitability of the group. He said: “We believe that it is essential that operational management maintains its greater focus on organic growth as the group seeks to drive home a competitive advantage from its trading momentum. In Retail, Greene King is pursuing a pragmatic range of options including packages, single site acquisition (mostly freehold but maybe the right kind of leasehold tenure or location), new builds, and reverse transferring some tenanted pubs. This organic activity has been augmented by around £750m of net M&A spend since 2005, generating returns around 350 bps above group WACC, with plenty of scope for more small pub company deals. “These actions so far have enabled the group to expand its already significant exposure to the UK’s most economically wealthy region, with over 55% of the total pub estate now based in London and the South East. The group’s food-led branded Destination and London retail pubs now account for 60% of retail revenues and 47% of the retail pub estate. From here, the group needs to prove that the profits generated and types of businesses acquired are delivering superior returns for shareholders.” Can growth in tenancies & leases be regenerated? Collyer said: “We are forecasting this deliberately shrinking division to move its contribution from around 34% of group EBITA in FY’10 to less than around 22% by FY’15E. The five year plan should weed out the least profitable pubs, while at the same time introducing a number of different formats that will allow the group to gain a greater control of the retail offering within its tenanted estate – something that is possible as Greene King is also a retailer and can utilise and share best retail practice with its independent licensees. “At the end of FY’12, this closer control had extended to 27% of the T&L estate. The key issue for Greene King is that these developments should help to offset some of the dilution from the programme of scaling down the overall estate size, and thereby enabling more of the progress being made by repositioning the retail estate to fall through to the bottom line.” Will Greene King continue to outperform the UK consumer space? Collyer said that Greene King has consistently been one of the top operational performers through the difficult trading period endured by the sector since mid 2007. He said it was also one of only two pub groups that have now caught up with the 2007 earnings high point, despite the dilution from its rights issue. He said: “In short, Greene King is outperforming many other retailers both in the pub and restaurant sector and the wider retail sector, and is forecast to grow both absolute and relative EBITA, taking profitable market share from its competitive set. “According to ONS data, the ‘out of home’ spend on food, soft drinks and alcohol is worth around £70bn a year vs. the ‘in home’ of £103bn. According to Horizons, the eating out competitive set is more like 250,000 outlets – with pubs and restaurants accounting for just 24% of outlets. We estimate Greene King’s share of the eating out market at just 1.2% - and it is the second largest pub retailer by profit. In our view Greene King has both the operational skills and the balance sheet to invest and drive home significant market share gains despite the dull outlook for the UK macro.” Is there scope for more M&A? Collyer said that the group still has plenty of firepower for similar sized pub company deals to those completed in recent years, but asks is there appetite or scope for something larger? He said: “We briefly discussed in our recent Greene King note (“Capital Connections”) that we saw the group as a natural buyer of Whitbread’s Restaurant business, if it ever came up for sale, and that we saw significant merit in a nil-premium merger with M&B. “This could have potential cultural and shareholder integration issues, but we can see, without assuming more than a 5% saving on purchasing, variable and central costs (£1.2bn in aggregate), that this could generate EPS-enhancement in the region of 15% for both Greene King and M&B shareholders. This would be before any re-rating potential as a post-deal EBITA multiple would be 22% lower than Spirit’s and 6% lower than JD Wetherspoon. Given the improved scale (over £800m of EBITDA) and better balance sheet (c. 4.5x net debt/EBITDA; over 90% freehold property), one would have thought that a re-rating post successful integration would be forthcoming.” Valuation & Risk Collyer values Greene King on a 12x FY’13E EBITA multiple, which he said reflected the better position that the group has engineered for itself through a programme of “value accretive M&A and a superior operating performance”. He said: “The principal downside risks to our Greene King recommendation and forecasts are: (i) operational, notably a failure to deliver on the implied profit uplifts from investing the proceeds of the recent rights issue and generate returns above historic investment levels; (ii) a collapse in the eating-out market – which generates around 65% of the group's retail sales. Plus (iii) a greater than expected impact from the deteriorating UK economy, coupled with increasing input cost inflation.”