M&C Report takes a closer look at the full-year results to 30 September for Enterprise Inns and talks to chief operating officer Simon Townsend on Waverley, tax, the Olympics, publican support, capex, pub values and the north-south divide. Front foot Townsend said that after a few years of being on the back foot the group was now on the front foot in terms of capital expenditure and operational opportunities. He said: “What has happened over the past few years has put us in a position where we are better informed, have better tactics, can make better choices, can be more considered and innovative. We now have a greater operational resource to aid our publicans and fewer pubs per regional manager. I feel energised by the quality of the people and the work that is going into reinvigorating the Enterprise offer.” Tax Like-for-like rents have fallen 12% and average beer discounts have risen 75% since 2008, said Townsend. “We estimate this to be worth some £54m of value transfer from the company to our licensees, equivalent to more than £9,000 per pub. We estimate that average licensee income is around £45,000 per annum, including the £10,000-a-year live-in benefit. Our income per pub currently stands at £65,000 per annum, while the Government/HMRC takes an annual £145,000 in VAT, duty and other taxes for each pub in the estate. This has risen by 19% from £122,000 in 2008. So you can see who is getting the biggest slice of the cake.” Pub estate and capex Townsend said that the group invested £63m on enhancing the quality of its freehold estate during the year. The estate now comprises 6,060 properties with a book value of £4.3bn. The property portfolio comprises 5,902 trading pubs and 158 properties which are alternative use outlets or properties permanently closed or trading on short term agreements pending disposal. Townsend said that the group planned to invest a total of c£180m over the next three years in “positioning its pubs for growth”. He said: “Over the next three years we expect the estate to reduce to approximately 5,200 pubs. Over the same period we plan to maintain our level of investment and spend approximately £180m to improve the quality of our estate. In the recent past, a significant proportion of our capital expenditure has of necessity been defensive in nature, ensuring basic functionality is in place to enable a continuation of trade. Looking forward we plan to direct an increasing proportion of our capital expenditure on growth-driving activities, where appropriate repositioning pub businesses to meet the changing needs of their local customer base.” He said the investment would be focused on developing food and accommodation offers and there would be a concentration on property condition, “kerb appeal”. He said around £10m would be spent on larger schemes worth £250,000 or more in the coming year, pubs in good locations and with high quality licensees. He also said that the group had identified 700 pubs where the external condition was “poor”, all of which will be addressed in the next 12 months. Pub values The company said that at the year end it had 1,049 pubs valued at more than £1m, with an average pub value of £1.25m and a total value of just over £1.3bn. 1,420 pubs were valued at between £750k to £1m, with an average value of £856k and a total value of £1.2bn. The majority of the group’s estate (2,037) is valued at between £500k to £750k, with an average value of £624k and a total segment value of £1.27bn. It has just over 1,000 pubs valued at between £250k and £500k, with an average value of £402k and a total segment value of £403m. Its total trading pub estate stands at 5,902 pubs, with an average value of £720k, and a total value of £4.25bn. It has 148 non-viable pubs, with an average value of £282k, and a total value of £42m. Disposals The group said that total net proceeds received from its disposal programme in the year amounted to £208m. It disposed of 301 properties in the year, of which 199 were unsustainable pubs generating net proceeds of £67m and 102 were exceptional properties generating net proceeds of £117m at an average multiple of 14 times income. A further 17 were sold as a sale and leaseback package for net proceeds of £24m at an average rental yield of 6.9%. Townsend said: “We will continue to dispose of unsustainable pubs as we enhance the quality of our retained estate and we will also capture opportunities to dispose of exceptional properties where we can realise cash proceeds above book value and at healthy multiples of income. We would not expect to complete further sale and leaseback transactions as we wish to preserve the largely freehold nature of our estate. Total disposal proceeds for the year to 30 September 2013 are expected to be in the region of £150m of which £40m is expected from our Unique estate.” WaverleyTBS Townsend said that the collapse of WaverleyTBS was likely to cost the company between £1.5m and £2m over the course of Q1 2013 after licensees exercised the contractual right to source supplies from elsewhere, depriving the company of income. He said: “It was worth £4.5m of margin and we estimate that it has cost up to £2m through a reduction in sales. We were given two days notice that Waverley was about to collapse and we are still trying to build back our order line. We are currently exploring a number of options in regards to alternative supply options.” Operating performance Townsend said that the rate of business failures had reduced by 4% during the year, with 85% of agreements having had rent reviewed or negotiated since 2008. During the year, 653 rent reviews were completed at an average annual reduction of 0.7% compared to 724 in 2011 at a reduction of 1.7%. 68% of substantive agreements are now linked to RPI (2011 – 65%), while 85% of publicans were receiving some form of BCF discount (2011: 81%). At the same time, overdue balances have been reduced by 20% to £4m. Licensee support “In an attempt to prevent outright failure we have continued to provide temporary concessions to publicans where appropriate, and have seen this cost reduce from £15m last year to £6m in 2012,” said Townsend. “Some of this reduction has been embedded in amended terms for good publicans because we acknowledge the permanent nature of changes in the market within which they operate. However we have also removed concessions where it is clear that a change of publican is the best outcome for the trading prospects of the pub. “Another cost associated with business failure is the bad debt that may arise on the departure of the publican. It is reassuring that the underlying cost of bad debt in the year has reduced to £1.3m (2011: £1.5m), with the level of overdue balances also down to £4m (2011: £5m), representing only 0.6% of turnover.” Olympics Tuppen said that the company would have achieved flat like-for-like income in the second half of it’s the year if it hadn’t have been for the Olympics where “sales were close to mid-January levels during the two weeks”. He estimated that the company lost 12,000 barrels of beer volume during the two weeks of the Games. Approach to the tie Townsend said: “Our approach to the tie has continued to evolve, and free-of-tie options for bottled beers, ciders and flavoured alcoholic beverages ("FABs"), wines, spirits and minerals, gaming machines and guest ales are available in every new agreement. Where circumstances have been compelling to both parties, we have been able to agree completely free-of-tie terms. This suite of available options ensures that all publicans' needs can be met, whether at the time of a new agreement, or in order to sustain and evolve an existing relationship. Project Beacon Townsend said that the group had increased the number of outlets operating under the Beacon format to 254 (2011: 90) and were encouraged by its results, but said that only c.50 further conversions are expected. He said: “They are typically smaller, wet-led pubs with an average net income of around £35,000 but which have delivered significantly improved net income when compared to the three months prior to conversion. Aligned with our successful disposal programme, we believe there is a natural limit to the number of our pubs that would benefit from this particular product offer and method of operation and now anticipate a total population of around 300 pubs to operate to this format. We are extending the lessons learnt from Beacon to develop other concepts where food, sport or family are the more central elements of the pub offer, and we already have one trial site successfully operating a carvery concept.” The group launched its first Classic Carvery site under the scheme earlier this year at the Star Inn at Winscombe, north Somerset. Townsend said that the site was generating sales of £15,000 a week but that it was going to wait before opening a further unit under the format. He said that in half a dozen sites in the North a greater emphasis was being placed on a sports offer, but “wouldn’t describe it as a full concept”. He also confirmed that the group was keen a trial a “Blazing Grill” format at a site in the future, but was determined not to “over extend what we were are already doing”. Total estate like-for-like net income - geography The group said that it was increasingly experiencing divergent trading conditions by geography. Tuppen said that the south (2,234 pubs), representing 42% of total net income, was growing at 1.2% assisted by the effects of a strong London economy. The company operates 1,899 across the centre of the country, which generated net income of £120m last year, a net income change of -2.4%. It operates 1,769 pubs across the north, generating £112m on net income, a drop of 3.4%. Tuppen said: “The agenda for our southern team is a growth strategy, prioritising investment opportunities and ensuring our publican selection process leads to optimal performance. In the north our team faces a different set of challenges. Our net income is down 3.4% as economic pressures provide difficult conditions for publicans and their customers and our team focuses on minimising the risk of business failure. In the central region our net income is down 2.4% as elements of the characteristics of both the north and south are evident. The operational reorganisation that we implemented this year was designed to recognise that each territory had different challenges and that the local teams required the flexibility to implement different strategies.” Total estate like-for-like net income - occupation Tuppen said that as the company looked towards total estate net income growth based upon stability, investment and driving sales performance, it was encouraging that where publicans have been in their pubs for more than one year, representing 81% of total net income, it has seen like-for-like growth of 2.2% in the financial year. Conversely those pubs where publicans have been in situ for less than a year, which stood at 1,543 at the year end, generated net income of £76m, 13.6% down on the previous year. He said: “These pubs represent a robust core to our business and we will continue to work in partnership with these publicans to enhance income for us both. Of the 1,543 pubs where the publican has been trading for less than one year, 903 were trading under new agreements where the publican was still at the beginning of establishing the business, and the balance of 640 pubs were either closed or trading under temporary agreements whilewe identify the correct long-term solution for the pub.” Assignment market Tuppen said that the company saw 140 assignments of leases in the past year, while “the number of assignments had halved over the past couple of years”. He said that that the collapse of the assignment market was a good thing since it meant that Enterprise was not coming across licensees who had spent a couple of hundred thousand pounds on an assignment premium just to start trading a pub. He said that demand “was generally high” for Enterprise leases in the south. He said: “We had 26 highly qualified applicants with fully-funded business plans applying to take over a pub in Islington, with less than 10 in the Greater London area (out of c800) available to let.” Outlook The group said it will focus on achieving like-for-like net income for the entire estate before restoring the business to sustainable growth in EPS. It will continue to use available cash to reduce debt as it aims to create value for shareholders through the long-term transfer of value from debt to equity. Tuppen said that in terms of trading, the group would be “buying and selling smarter” going forward and would continue to maximise value from high-value and tail-end disposals. He said: “We are now focused on returning the business to growth, through a number of initiatives that we believe will continue to generate significant cash flows that we will use to reduce our debts and deliver value for shareholders.” Analyst reaction Douglas Jack at Numis said: “Full year PBT, down 13% to £137m, is in line with our forecast and consensus due to LFL net income falling 1.2%. EBITDA fell 7%, outpaced by net debt, which fell by 9%. There are clear signs that LFL net income is stabilising, whereas net debt is forecast to continue to fall rapidly (by c.9% in 2013E; versus EBITDA falling c.5%), creating further equity value in 2013E. In 2012, Enterprise refinanced its bank debt to June 2016, found a way to avoid the Unique bonds being cash trapped and achieved estate/operational improvements that should help LFL trading to stabilise further in 2013E. Our 110p target price equates to 9.5x EV/EBITDA (or 19% equity free cash flow yield), in line with the company’s valuation in 2009 and 2010.” Simon French at Panmure Gordon said: “No further material purchases of securitised bonds are required following the purchase of £63m A4 bonds and £2m A3 bonds which will keep the group one year ahead of the schedule debt profile. The group will look to explore the opportunity of extending the term its £60m corporate bond due February 2014 although it has the resources to repay it from cash flow should it not be able to extend the maturity. We expect no material change to consensus forecasts today and the stock trades on a CY 2013E adj EV/EBITDAR of 8.6x. Given the improving trading trends and falling debt we think the stock continues to offer significant upside potential. We reiterate our Buy recommendation and 87p Target Price, implying c30% upside potential.” Geof Collyer at Deutsche Bank said: “The bank debt has been rolled into a new £220m forward start, extending the maturity to May 2016 – by which time we see the requirement for any short term bank debt being little more than a ‘general purposes unsecured facility’. Enough Unique bonds have been bought back to satisfy the debt service covenant. We expect that all of the cash flow over the next three years will be used to further reduce debt and with these issues being resolved, we see most if not all of these repayments transferring to the equity value. We estimate this figure at over £520m, including £300m of disposal proceeds and £225m of free cash flow (net of £180m of capex) vs. the current market cap of £330m.”

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