It is likely to be a bumpy ride.
The Company
Enterprise Inns is a UK based
company which operates a leased and tenanted pub model. The company owned 5,069
pubs as at September 2015 within an overall market of approximately 47,000
pubs. Majority of its pubs (c.95%) are leased to the tenants (who are commonly
referred to as Publican) under the so called – ‘beer tie’ or ‘tie’.
Source: Enterprise Inns Annual report
As can be seen from the diagram above, under the ‘tie’:
As can be seen from the diagram above, under the ‘tie’:
- the Publican must buy all their beer, and some other supplies from the PubCo (typically at a higher rate than the wholesale price). This is commonly referred to as the ‘wet rent’;
- the Publican must also pay rent to the PubCo. The rent is typically arranged at 50% of the projected profits at the start of the lease, with generally an upward only rent review provision;
- in addition to the above, a percentage of income from amusement with prizes machines (AWPs) – you may have dabbled in fruit and quiz machines in your time at the Pub – goes to the PubCo.
The
rationale behind the ‘tie’ is that it offers the Publican an easy access to the
business – they don’t need the capital to buy/own a Pub to get started, and the
PubCo can use its economies of scale to buy other services in the cheap for the Publican
(e.g. insurance, satellite television, fittings/maintenance etc.). Also, the
model is supposed to have a better alignment of interest between the PubCo and
its Publican –PubCo charges a lower fixed rent, and makes most of its money via
drink sales; ergo, when the Publican does well, the PubCo does well, and
vice-versa.
There has been a huge amount of criticism
of the ‘tie’ of late, resulting in the UK bringing in new regulations – which
will take effect from March 2016 – making it mandatory for the PubCos to offer
its Publican’s and option to go ‘free of tie’ at the point of lease renewals
(more on this later).
Enterprise
Inns also operates 213 Pubs ‘free of tie’ where it simply collects rents; and,
it currently has 35 Pubs that it manages directly. Both the ‘free of tie’ and
‘managed’ pub numbers are set to rise significantly over the next 5 years, with
the ‘tie’ Pub numbers set to fall.
The stock
The chart
below show’s how the stock has performed over the last 5 years
As can be
seen, the stock hasn’t done anything for someone who has stayed the
journey. That said, if one had purchased the stock towards the end of 2011 or in early 2012 (when it touched the lows of 28p), they could have had a 3x-4x return. The question
today is where is the stock now? In particular, is it a value opportunity?
Coming back
to point, the stock currently trades at 103p; this equates to PE multiple
of 5.3 and EV/EBITDA multiple of 9.8 (based TTM). The sector typically trades
at a EV/EBITDA multiple of between 9X – 11X. On that basis, the shares don’t
seem to be trading at a significant discount.
The other
point worth noting is the discount to NAV, which currently stands at over 60%. The
NAV per share as at Sep15 stood at 270p versus the share price today of 103p.
This is all the more interesting because the company undertook an external
valuation of almost all of its Pubs recently underpinning the 270p per share
NAV (previously the company did most of the valuation in-house). If one assumes
– as one should – that valuation reflects
the current and future rent and other income streams expected to be generated
by each property, capitalised using an appropriate multiple, then the market is
mispricing the shares. But is it?
Before we
get into answering that question, it is worth nothing the trading history of
the stock compared to NAV
Source: Enterprise Inns 2013 Results presentation
As can be seen in the chart above, the stock was trading at a significant premium to NAV until the property markets tanked in 2008. Since then, the discount to NAV narrowed from 88% to 49% between 2011 and 2013, but it has turned up again and currently stands at just over 60%.
As can be seen in the chart above, the stock was trading at a significant premium to NAV until the property markets tanked in 2008. Since then, the discount to NAV narrowed from 88% to 49% between 2011 and 2013, but it has turned up again and currently stands at just over 60%.
In my
opinion, the pre-2008 premium to NAV was clearly not justified; but at the same
time, is the current discount to NAV justified?
The only way
to answer that question is by determining the intrinsic value for the stock.
But before we do that, it is helpful to take stock of three very important
factors which have a material impact in this exercise.
1. The state of pubs
‘When you have
lost your inns, drown your empty selves, for you will have lost the last of
England.’
Hilaire
Belloc (1912)
If the famous Anglo-French writer and historian, Hilarie Belloc, got to
see us today, he will likely declare that the time for the people of England to
drown their empty selves may be approaching soon.
The future
of pubs in the UK has been high on the political agenda for a few years now.
Depending on source, anywhere between 20 and 30 pubs are closing shop at present.
In 1980 there were c70,000 pubs in the UK; the number now stands at c47,000.
Source: http://www.iea.org.uk/sites/default/files/publications/files/Briefing_Closing%20time_web.pdf
As can be seen from the graph above, the closure rate has been particularly alarming since
the 2008 recession. The number of pubs plummeted from 58,200 in 2006
to 48,000 in 2013, a drop of 18 per cent in just seven years (BBPA). The peak
in pub closures came in 2009, with 52 pubs shutting down each week, but pubs
were still closing at a rate of 20-30 a week in mid-2014.
People's drinking habits have changed
There is no
doubting the fact that people’s drinking habits have changed over the years. There
is more choices today – from cheap supermarket beer, to quality wines from all
across the globe. Also, the coffee shop is partly acting as the social hub for
the discerning professional. In addition, things like the smoking ban (smokers
on average tend to consume more alcohol than non-smokers), VAT, and alcohol
duties have not helped. And, there is the small matter of the explosion in home
entertainment (internet and satellite TV), which has domesticated a lot of the
men folks. All these factors combined has meant that people don’t frequent the
Pubs as they used to.
The following two chart’s capture this point nicely:
Beer vs Coffee
Source: FT
Per capita alcohol consumption (litres)
Source: http://www.iea.org.uk/sites/default/files/publications/files/Briefing_Closing%20time_web.pdf
Smoking ban and Pub numbers
Source: http://www.iea.org.uk/sites/default/files/publications/files/Briefing_Closing%20time_web.pdf
Enterprise,
like all other Pub owners, has not been immune to this change. At its height,
Enterprise had over 9,000 pubs. Since 2008, the company has sold many
pubs, with 5,069 remaining at the end of September 2015.
That said, Pubs are not going to disappear from
the UK. There has been a massive shake up, but the process will most likely
lead to profitable pubs. Pubs that will remain, will be evolved, and profitable
– already we are seeing pubs offering food and variety.
A number of stakeholders interviewed by
London Economics for a report to the Department for Business, Innovation and
skills on the impact of policy changes (see Incoming regulation below noted
that a sustainable number of pubs in the UK would be 45,000. We are almost at
that level now.
2. Incoming regulation – Market Rent
Only (MRO) option
In a debate
on Pubs and the ‘Beer tie’ in the UK parliament on 21 January 2014, the then
Secretary of State, Vince Cable, addressed the question of whether tied pubs
were more vulnerable to going out of business than independent or free-of-tie
pubs. After saying that there was no clear evidence to suggest that tied pubs
were more vulnerable to closure than free-of-tie pubs, Mr Cable went on to say:
This is not fundamentally an argument about
pub closures; it is essentially about the unfairness of and inequalities in the
relationship … To us, the essential point is best captured in the work done by
CAMRA that suggests that 57% of tied tenants earn less than £10,000 a year. If
we apply that to 35-hour week, 48 weeks a year, we are talking about less than
£6 an hour, which means that people are working for considerably less than the
minimum wage. Since many work much longer hours, that means that this is a very
low-paid industry. Many publicans are struggling. In contrast, only 25% of
those who are free of tie are on at the same income level. There is a striking
disparity, which is at the heart of the question.
The above quote from Mr Cable, in essence, captures the rationale
behind the new regulations – MRO option – being introduced from May 2016. Broadly, the Market Rent
Only (MRO) option allows the Publican to go free-of-tie, effectively ending the
need to buy beer from the PubCo (with the exception of buildings’ insurance).
The PubCo would effectively cease to have any direct involvement in the trading
operations and the PubCo – Publican relationship would be that of a pure
landlord and tenant. Under the MRO the Publican can request the free-of-tie
option either at rent review time or at lease renewal, after the law comes into
effect in May 2016. The MRO only applies to PubCo which own over 500 pubs –
broadly, the affected companies will be Enterprise, Punch, Admiral, Green King,
Star, and Marstons. The total number of Pubs that will be affected is expected
to be approximately 13,000; of which Enterprise has 4,821 – by far the largest
share (Punch comes next).
There is no question of the fact that MRO is a negative for the PubCos.
Its effect will be a transfer of wealth from the PubCos to the Publican –
currently, a larger share of the wealth is being captured by the PubCo under
the ‘tie’; by allowing the Publican to buy his beer in the open market, the MRO
will erode the margin that the PubCo gets to keep as the middle man.
For enterprise, there are two important points to note:
-
Its portfolio
will look fundamentally different in 5 year’ time, by which time almost all of
its tied pubs should have had a rent review, with the Publican having selected
whether or not to go free-of-tie. The company anticipates 200 MRO events in
2016, and some 600 such events per year thereafter. Therefore, by the end of
2020, it could find itself owning no Pubs under ‘tie’, if all of its tied
Publicans chose the free-of-tie option under the MRO. Management is spending a
lot of effort trying to convince its Publicans of the benefits of staying with
the ‘tie’, however, even Management expects a significantly reduced portfolio
of tied pubs. Broadly, of the c4200 pubs at the end of Sep 2020, Management
expects that c2400 will be ‘tied’.
-
With little ‘base
rate’ data, it is difficult to calculate the precise wealth transfer that will
result from the MRO. But we can make a reasonable start with the data that is
available. Based on the data available from the existing 213 free-of-tie pubs I
we know that the rents from the free-of-tie pubs is c60k per annum. And, analysing
the last six years financials, we can calculate the gross profit per tied pub
(revenue less COGS) as c72k per pub. Therefore, based on current best
estimates, we get a c12k per pub of gross profit reduction when moving from a
‘tie’ to ‘free-of-tie’.
In addition, Enterprise will not spend the same amount it currently
spends in capex and improvements if a pub is ‘free-of-tie’. I have assumed a
40% drop in capex for ‘free-of-tie’ pubs.
3. The Debt
Enterprise came close to insolvency during the
financial crisis, thanks mainly to its debt level which stood at 8 times EBITDA
in 2010. Enterprise’s net debt is now down to £2.3bn, but still stands at very
high 7.8 times EBITDA. From a Loan-to-Value perspective, the property assets
are valued at £3.7bn – giving a LTV of 62%. The chief risks on the debt are:
Liquidity risk: The Company has on average required c176m per year of interest and other payments over the last 5 years. This eats into substantial part of its free cash flow, leaving little freedom in operations.
Refinancing risk: The Company has c350m of debt that needs to be refinance in 2018; and a total of c1.5bln that needs to be refinanced in the next 10 years. This is significant amount of debt to refinance.
Property values: The property portfolio has been falling steadily over the years – both due to sales, and due to write-downs. In the year ending September 2015, the company took a write-down of c121m to its property portfolio. The risk is that the property portfolio falls at a faster rate to debt, this risk is compounded by the significant change that is coming due to the MRO.
Driven by the MRO, Enterprise, in May 2015, announced a radical change to the shape of its business. The key points coming out of the revised strategy are:
-
plans to
sell c1000 pubs over the next 5 years;
-
plans to
significantly increase the number of pubs under its own management, from the
current 35 to c800 in the next 5 years; and,
-
at the end
of 5 years, Enterprise expects to have c2400 pubs under the ‘tie’ and c1000
pubs under ‘free-of-tie’. In addition, it plans to spin-off the ‘free-of-tie’
portfolio as a REIT.
Source: Enterprise Inns preliminary presentation September 2015
-
a
significant proportion of the returns are projected from converting ‘tied’ pubs
to managed house. Managed houses could bring with them significant volatility
due to higher operational gearing inherent in it. Moreover, executing 800 managed
house formats – requiring branding, tie-ups, capex etc. - will be a significant
challenge.
-
although
the group should have sufficient cash flow to execute the plan based on current
forecast from trade and proceeds from sale of pubs, there will be little breathing room. Any change to forecast
– be it at the income level or with capex, could present problems.
Intrinsic value estimate
Given the significant uncertainty due to the MRO, the degree of added risk due to debt, and the execution risk under the new strategic plan, the range of possible outcomes at this stage are many. With this in mind, I have calculated the intrinsic value using a range of possible outcomes which I believe best capture the uncertainty as we stand today.
The valuation summary shows my predicted share price for 35 scenarios – for 6 different pub mixes between tied, free of tie, and managed, and for 5 different total number of pubs at September 2020.
If management execute on their current strategy to the dot, and everything works out perfectly, then the shares are worth 133.87p (the top right hand corner of the summary). However, average price I get for the range of outcomes is 67.29p. Therefore, in my opinion, as a value investor, the stock is overpriced given the risk. Although it is not a buy for me at current levels, I will continue to monitor the situation as it evolves.
Afterword
Enterprise may have let down its shareholders, but it has certainly been good to its debt holders. The company pays an average interest rate of 6.3% on its £2.4bln of debt – a combination of bank debt (£75m), convertible bond (£97m), a large trance of corporate bond (£1.1bln), and securitized bond (£1.1bln). Back in the summer of 2011, its 2018 corporate bonds traded at mid-seventies, pushing the yield to 12%. The buyers then ended up making a decent turn with much lower risk than in the equity.
The bonds seem fairly priced now, but they are certainly worth a watch. Any distress, and it might be a better idea to enter into the bonds, than the equity.
By the way, the convertible bond doesn’t seem that much of a value for money at present. It only pays a coupon of 3.5% (compared to the bonds which average 6.5%), and the conversion price is at £1.91 a share at September 2020. Based on current predictions, I can’t see much value in this, unless it is trading at a significant discount.
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