Leading analyst Douglas Jack at Numis Securities says that companies that locked purchasing terms in during the spring/early summer should now be benefiting from lower food and energy cost inflation.
He says: “JD Wetherspoon faces further margin downside risk in H2 2013E due to higher costs and an aggressive pricing strategy. The Restaurant Group also faces margin downside in 2013E if its high pace of drinks price increases slows. Amongst the managed operators, Spirit Pub Company offers the greatest margin upside, in our view.
“Share prices appear to be most heavily influenced by LFL sales, which is partly justified by their correlation to margins via operational gearing. JD Wetherspoon is big exception to this correlation, having suffered a 101bps reduction in margins during H2 2012 despite LFL sales rising by 4.3%. This reflects the company not passing on all its cost increases; a trend that has continued into early 2013E, during which LFL sales have risen by 8.4%.”
Jack says that JD Wetherspoon and The Restaurant Group have the most divergent drinks price strategies. He says: In the year to June, average beer/cider drinks prices rose: 11.5% for The
Restaurant Group; and 3.0% for JD Wetherspoon. Raising drink prices is easier for restaurants due to consumers’ initial focus being on food rather than drink prices. Combined with using food promotions to drive footfall, this is an effective way to boost LFL sales up to the point that ‘bill shock’ disenfranchises customers. Pubs have greater scope than restaurants to raise food prices, in our view. However, pub drinks prices are more demand elastic than restaurants’ and are more dependent on changing the sales mix (premiumisation, similar to food in restaurants).”
He says that having previously intended to hold EBIT margins above 10%, JD Wetherspoon has allowed margins to slip below 9%. He says: “The company’s strong recent LFL sales should, in our view, enable margins to recover slightly in H1 2013E, but we believe tougher LFL sales comparatives and new cost pressures are likely to result in the company suffering another lurch down in margins in H2 2013E. The Restaurant Group only managed to maintain margins in H1 2012 with 11.6% higher drinks prices and 3.25% LFL sales, offsetting higher costs and more competitive food pricing.”
Jacks says that The Restaurant Group is becoming more competitive on food pricing, by not raising prices by as much as its restaurant competitors and becoming more involved in voucher promotional activity.
He says: “In its out-of-town locations, the company will increasingly compete with lower-priced pub operators in the future. In our view, management deserves credit for its margin strategy in H1 2012. This brought big benefits, but also raises concerns: As customers tend to focus on food prices/quality when choosing restaurants, big drinks price increases would have boosted both LFL sales (as drinks prices rose 11.6%; drink volume must have fallen 8%) and margins. However, double-digit annual drinks price increases are not sustainable. Eventually, they create ‘bill shock’, which tends to reduce repeat visits. As the company has only two product categories, both volume and price constrained, the company has a lack of alternatives (to large drink price rises) to maintain margins.”
Jack says that The Restaurant Group and Prezzo are less exposed to higher food/energy costs by having a relatively low cost of sales ratio (due to having higher food prices). He says that JD Wetherspoon is the most exposed, with utilities and purchasing equating to 39% of sales, reflecting “a higher proportional cost of sales due to its low relative pricing”.
Of the managed operators, Jack says that Spirit Pub Company offers the best opportunity to grow margins. He says: “In our view, predominantly through a sales recovery, boosted by a 79%-complete investment programme. On average, if operators price to maintain food P&L margins and drink cash margins, average profits should be maintained if volumes are flat. This would require LFL sales growth of 2.5% in 2013E, before cost mitigation, by our estimates.”
