M&C Report takes a closer look at the fourth quarter trading update from Spirit Pub Company, the managed pub operator: Refurbishments and conversions Chief executive Ian Dyson said Spirit is “on track” with refurbishments, with about 60% completed to date. Asked whether the company planned to “tweak” the number of sites in each brand, deputy chief executive Mike Tye said: “I don’t see anything so far that would change our view on our brand portfolio. We are in good shape and there are no plans for change.” He said the roll out of Chef & Brewer (target: 140 sites) is “already finished”, while the number of Fayre & Square sites now number almost 100 (target: 130), with around 50 Flaming Grills (target: 90). The roll out of John Barras (target: 130) and Original Pub Company (target: 80) has begun, he added, while Taylor Walker conversions (target: 110) are “almost finished”. Tye said Spirit is standing by its plans for its six core brands, “which the consumer and the results are telling us are the right brands”. Cash returns of 25% are still being maintained at the converted outlets, Tye said. “The sites pick up their new sales levels pretty fast,” he added. Leased to managed conversions Dyson said Spirit is planning to covert between 20 and 25 of its leased pubs to managed each year; two have been converted so far. Asked if he expects to have to pay tenants to leave their pubs, Dyson replied: “We expect to have do to a deal with the majority. The ones done to date are on TaWs [tenancy at will agreements]. That’s where the initial focus will be.” He said that “over time”, as Spirit moves towards the figure of 100 conversions, “we will need to do a deal” with the tenants and lessees. Around 30 sites in the leased division are currently not trading. Margins against competitors Tye said Spirit has made “real progress” closing the gap on margins with its competitors, although the full year results on 20 October will “reveal all”. Discounting Tye said: “We have made a real effort this year to reduce the amount of discounting we are doing, and try to present ourselves as really great value for money for everybody at any time.” He said that the industry as a whole was being “pretty sensible” when it comes to discounting. “There are some [competitors] that are increasing discounting. We keep a very close check on this and overall there hasn’t been a massive uptake so far, no silly, aggressive offers.” Tye said operators are aware that “really big sales volumes” are needed to maintain margins if they discount heavily. Cost pressures Tye said the demerged Spirit business has “created very good relationships with all drinks suppliers”. In terms of food, Tye said: “Like everybody, we’ve faced some fairly excessive cost pressures in the last 12 months.” He stressed that the “biggest worry” is alcohol duty, especially with the alcohol duty escalator varying according to the retail price index. The London/south east ‘bubble’ Addressing the so-called London and south east trading ‘bubble’, Tye said: “So far that’s been the case.” However, the view that consumers are now feeling under pressure in the south east “does make sense”, he added. “So far so good, [but] we are very clear that people are under pressure on disposable income.” Nationally, Tye said there are “some differences” in trading depending on local economic activity, but sites in less economically vibrant areas tend to be more value-led. “In areas that are less economically active, a greater proportion of our sites are in the value sectors. We pretty much match the demography of the UK.” Christmas bookings Tye said Spirit has already had “a lot” of bookings for Christmas. “We were first to market last year and pretty much first to market this year also,” he said. “Over the August bank holiday weekend we had Christmas displays in every pub, we had booking forms out. There’s a lot of interest out there and I think we will have a good Christmas.” Impact of the riots Spirit closed between 30 and 40 sites over the two days of rioting last month, either as a company decision or when asked by police, Tye said. The sales impact wasn’t just felt at outlets in or near the rioting, he said. “Over the days of the riots and immediately after we saw a strong sales dip, a few percentage points. I think people just lost a little more confidence in wanting to go out. I think, broadly, it has come back but it definitely did hurt for a few weeks.” Analysts Lindsey Kerrigan at Panmure Gordon, said Spirit’s like-for-like sales of 5.2% were above Panmure Gordon’s forecast of 5%. “Management anticipates full-year results to be in-line with current market expectations. The group trades on a FY 2012E adjusted EV/ebitdar of 7.6x and a P/E of 8.9x. Following its demerger from Punch Taverns, share price performance has been volatile. We reiterate our Hold recommendation and 48p TP. “Management seem confident it can mostly offset food and energy price increases into FY 2012E. Ultimately, Spirit will become a pure-play managed pub business. “Over the next two years it will convert around 100 pubs from the leased estate into managed pubs. The process has now begun, with two conversions having been completed. Further value should be unlocked by the sale of c450 leased pubs within the securitisation but this will require bondholder approval. “We forecast 14.6% CAGR in EPS over the next three years with dividends payable from FY 2012E growing in line with earnings. Key catalysts for outperformance are the closing of the profit-per outlet gap, disposal of the c450 leased pubs and a potential bid approach. For FY 2011E we forecast £46.5m PBT (5.3p EPS) rising to £51.0m PBT (5.7p EPS) for 2012E. Our forecasts are in line with consensus expectations of £45.8m PBT (5.1p EPS) in FY 2011E and £51.8m PBT (5.9p EPS) in FY 2012E.” Kerridgan said the possibility of closing the profit-per-outlet gap relative to its peers “represents an opportunity for value creation”. Panmure Gordon does “not believe Spirit should trade at a premium to its nearest peers (Mitchells & Butlers, The Restaurant Group and JD Wetherspoon)”. “We reiterate our Hold recommendation and 48p per share target price based on our sum-of-the parts analysis valuing the managed division at 7.0x FY 2012E adjusted EV/ebitdar and the leased division at 8.7x FY 2012E adjusted EV/ebitdar, in line with the respective peer group companies.” Douglas Jack at Numis issued a Buy recommendation, at a target price of 75p, and said: “We are holding our forecasts which anticipate a 15% earnings CAGR to 2013E, during which we expect net debt:ebitda to fall from 5.2x to 4.5x despite an intention to pay dividends that should yield 4.6% in 2012E, by our estimates. “We would buy the shares as we believe the share price currently undervalues the company’s growth prospects.” Jack said the 7.9% rise in LFL food sales in Q4, against 7.2% over the full year, implies that “trading in the food-led estate has remained strong in Q4 despite the less favourable weather”. “LFL drink sales rose 1.2% in Q4 versus 4.0% over the full year, with the Q4 LFL slowdown due to the strength of wet trade during the 2010 World Cup. “Two hundred and fifteen major refurbishments/re-brandings were completed in 2011E. We believe these projects have continued to achieve the 25% cash ROI target. The leased to managed conversion programme has only just started, with two sites already completed. The leased estate’s LFL net income fell 3.3% in Q4, with the trend improving in H2 (LFL net income fell 4.1% over the full year). Q4 was weaker than Q3’s -0.7%, largely due to tough World Cup comparatives in Q4. “We believe Spirit’s valuation does not fully reflect what it has achieved in 2011E, the potential for further growth through to 2014E, improving earnings quality and an ability to reduce net debt:ebitda despite proposing an attractive dividend policy. Potential for corporate activity should cap the downside.” Paul Hickman at Peel Hunt issued a Buy recommendation and said: “The shares are undervalued at PER 8.1x, falling to 6.7x in FY2012E. “Performance remains in line, and as a result Spirit looks on course for double digit growth in FY2012E. Its sound balance sheet is adequate to finance the rest of its investment programme, while its main competitor, Mitchells & Butlers, is in danger of becoming demoralised." Mark Brumby at Langton Capital said: “Detractors may point to the execution risk (which remains significant) and to issues with the tenanted and reverted units which may remain troublesome and they may further suggest that, when 100% of the group’s units have been refurbished (up from the current 60%), then lfl trading could slow and there will be nowhere to hide. “Much of this is reflected in the company’s share price, which also reflects the potential for corporate activity. Details of debt, margins etc. were not given and the group will update further at its FY results meeting on 20 October. "Of perhaps particular interest was Mr. Tye’s comments that, though there has been no sign of it to date, London’s immunity to the current slowdown ‘may change in the future’.”

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