Wet-led venues are emerging from the shadows of casual dining and gastropubs with buoyant sales and less exposure to headwinds. Investors are clearly taking note, with wet-led businesses at the centre of much of the sector’s M&A activity over the past year. Sapient Corporate Finance founder, Peter Hansen, explains why he sees this segment going from strength to strength.

I walked through Greenwood at the Nova development across from Victoria Station on Saturday around 2pm, and it was rammed. This was hardly surprising given that the World Cup was on and the punters were enjoying a pint during the France vs Australia match. Greenwood, with its wet-led offer, is the most successful operator at Nova. Greenwood (part of ETM) focuses on sports and experiences such as shuffleboard, in comparison to the food-led operations at Nova, few of which appear to be busy. Although the food on offer at the development is varied, there is simply too much of it.

Nova is a microcosm of what is going on in the wider market. Food-led outlets, whether restaurants or pubs, are producing more interesting food than ever but the financial returns are declining. The market is tough. Food costs are up due in part to the decline in Sterling. The National Living Wage is increasing labour costs and food-led pubs need lots of labour. Labour costs at most food-led pubs exceed 30% of turnover. Throw in higher rent, rates and the Apprentice Levy and you have the perfect storm.

As if that wasn’t enough, most operators will tell you that finding chefs and kitchen staff is becoming increasingly difficult and Brexit isn’t helping matters. The NHS is struggling to get the government to relax immigration rules for doctors so it is hard to see restaurants and pubs getting much help either.

Why are food pubs all the rage? We have been here before. In the mid-90s during the heyday of the brands including Beefeater, Brewers Fayre, Chef & Brewer, Two for One and Harvester, the large managed pub operators were busy converting their large wet-led pubs to food operations. The food wasn’t particularly good but it was better than what had preceded it (The Chicago Pizza Pie Factory and Henry J Beans for those with long memories). PizzaExpress was just starting its roll out. Whitbread and M&B managed to convince their investors that the US market had higher levels of eating out of home and the UK was sure to follow.

During the last decade, there has been tremendous expansion in food capacity between the major managed operators including Greene King and M&B, not to mention the casual dining operators. With the support of private equity and lending banks, casual dining operators have been adding sites with abandon in an attempt to harness growth in eating out. And Deliveroo and Just Eat are competing with food operators by tempting consumers to eat at home. Competitive intensity is much higher in this cycle than it has been in the past. There are now clear signs of overcapacity with escalating rents that further damage returns. If the excess capacity that crippled wet-led high street pubs in the early 2000s is any measure, it will be years before conditions improve for the dining out market.

Ten years ago, just at the time as eating out was gaining momentum, wet-led pubs, by contrast, were having a torrid time. The smoking ban and the recession combined to make life very difficult for wet-led operators, particularly tenanted pubs, with many operators struggling with excessive rents. Punch and Enterprise sowed the seeds for the eventual recovery by selling pubs in record numbers and rebalancing economics between the pub company and the tenant. Punch, prior to its acquisition by Heineken and Patron, sold over 1,500 pubs, many of which were converted to alternative use.

As a result, at the same time that food-led operators were adding capacity, wet-led pubs were exiting the market. Large managed pub operators continued to convert wet-led pubs to food-led, further eroding capacity.

We are now at a point in the cycle where wet-led pubs have been trading as well or better than food-led pubs during the last three years. However, wet-led pubs are more profitable than food-led pubs for several reasons. Labour costs are lower, averaging closer to 25% of turnover, whereas food-led pubs typically average 30% or more. At a time when food operators are having to discount, all of the product innovation has been in the wet-led sector. Craft beer sells at a premium to standard and premium lagers, generating substantial cash margin. Craft gin is now all the rage and consumers are becoming interested in what wet-led pubs have to offer. This is particularly helpful for pub tenants since very few of them are tied for wines and spirits. The pubcos don’t mind because it helps increase the profitability of tenants, and they benefit from increased rents.

Capital costs are typically lower too. Wet-led pubs don’t need a kitchen, which can cost £100,000 or more for a big operation. And they usually have harder surfaces that don’t require the same replacement cycle as food operations.

The improvement in trading has not escaped the attention of brewers. Their traditional brands are losing share to craft beers and they have reacted in two ways. First, they have been acquiring craft beer brands (Heineken bought my favourite beer, Lagunitas IPA) to bolster their product line-up. In addition, they have been active in acquiring pubs, investing in pubcos or acquiring distribution. Heineken bought the 421 pubs in the Globe estate in 2009, the Galaxy estate in 2011 (918 pubs) and the 1,900 pubs in the Punch A securitisation last year. It has quietly become the second largest operator of tenanted pubs in the UK behind Ei Group. C&C Group acquired 48% of Admiral Taverns in December 2017 and more recently, the distribution assets of Matthew Clark. It is very unlikely that this is the last move we have seen from the brewers.

Property companies are approaching the tenanted sector with increasing sophistication, sometimes in partnership with brewers (Proprium is the joint venture partner with C&C Group in Admiral Taverns) and sometimes on their own. NewRiver just made its third acquisition since entering the pub sector in 2013, subsequently followed by the acquisition of 158 pubs from Punch Taverns in 2015 and most recently the acquisition of Hawthorn Leisure last month for £107m. Hawthorn provides a strong platform from which to expand further in the sector, so this is unlikely to be its last acquisition.

The irony is that wet led pubs, particularly tenancies, do not command a premium to food-led pubs. If anything, wet-led pubs are cheaper, partly because the banks have a long memory and they are still very selective on which operators they will back. One would hope that the current problems in the casual dining sector would cause them to reallocate capital to wet-led pubs but some lenders may withdraw from the sector altogether whilst they lick their wounds.

If you had to pick a market right now to back in the next five years, you would go wet-led. Strong margins, stable like-for-likes, lower reliance on skilled labour and lower capital costs will drive superior returns.

How long will it be before we see food-led pubs being converted back to wet-led in an attempt to solve labour shortages and improve returns?