A model to think about cyclicals – a Value Investor’s perspective

Let’s start off with a few quotes from some of the value investment greats.

 “Face up to two unpleasant facts: the future is never clear and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.” Warren Buffett

“The single greatest edge an investor can have is a long-term orientation.” Seth Klarman

"The best opportunities are usually found among things most others won't do." Howard Marks

“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” John Templeton

In this blog, I want to talk about a way to think about cyclical as a value investor. The above quotes pretty much sum things up – like uncertainty, have a long-term orientation, go where most others won’t, be skeptical. But, let’s also try drawing some specific conclusions – come up with a mental model to think about cyclical stocks.

Recently, I read a fantastic blog by the folks at The Value Perspective (http://www.thevalueperspective.co.uk/) – the team at Schroders who follow a value style in managing c£12bn of assets. I highly recommend their blog.

In one of their recent posts (http://www.thevalueperspective.co.uk/en/uk/the-value-perspective/blog/all-blogs/in-the-picture-ii/), I saw 3 pictures that I think sum up the way a value investor should think about cyclical's. As they say in their blog, a picture is worth at least two paragraphs:

Cycles

Source: http://www.thevalueperspective.co.uk/

As can be seen from the graph, cycles are recurring, fairly predictable, pattern of periodic fluctuations. They repeat themselves – typically every 5-7 years – in four stages – 1) expansion, 2) peak, 3) recession, and 4) recovery. Here is the important bit – nobody can really predict their timing; but, one can reasonably estimate in which stage of the cycle one stands today. It is important to note that having a good feel for which stage of the cycle we are in today is not the same as knowing what is going to happen tomorrow, or day after, or in a month, or year.

Cycles and market’s behavior

Source: http://www.thevalueperspective.co.uk/

Above is an ingenious way of picturing Market’s behavior during cycles. This is a great way to think about the Market for a value investor. Broadly, at the top of the cycle, the Market can only think of the good things that are going to happen- as implied by the positive skew; and, at the bottom of the cycle, the Market can only think of the bad things that are going to happen – as implied by the negative skew. This happens all the time – time after time. Just scan the news of late and you will find headlines like – “If China Killed Commodity Super Cycle, Fed Is About to Bury It”; and, scan the news from 5-7 years ago, and you will find that it’s all hunky-dory in the commodities world.

A Value Investor’s model for cycles

Source: http://www.thevalueperspective.co.uk/

The above picture sums up so much about value investing; if I have to sum up the key messages from the quotes at the beginning of this blog, this picture would do a nice job. Here are the key takeaways (paraphrased from The Value Perspective):

• longer time horizon allows us to see the cycle merely as points on the distribution curve around average profitability – i.e., a value investor doesn’t have a skewed outlook;
• by investing in businesses at the point of despair, when the wider market sees no chance of recovery, pushes the odds in favour, gets the forces of mean reversion on side; and,
• by investing when prices are low, gives us the best chance of superior long-term returns.

However, there are other risks that needs to be considered. The main ones being:

1. Is the decline really cyclical? Or, it this structural? – for example, is the commodity or the product likely to go permanently out of fashion or use.
2. Debt – If the business has very high level of debt, the equity holders risk being taken out during a prolonged downturn. This matters for a value investor, as he/she is in the game for the long-term, and debt threatens the long-term survival.
3. Operating leverage & break-even point – What is the gross profit margin? What is the proportion of fixed costs in the company’s cost structure? –gives an indication of earnings quality, and the company’s ability to sustain in a prolonged downturn.

Consider NMDC – India’s largest iron ore miner. The company has access to superior quality iron ore assets with reserve base of 1361 MT (~42 years at current production rate). It is 80% owned by the Government, with 20% free float. Its shares have fallen by more than a third this year. It has no debt on balance sheet; and enjoys very low costs - high level of mechanization and access to an inexpensive labour enables it to keep its costs at ~US$20/tonne (one of the lowest globally). Prices of iron ore have fallen significantly this year, and are currently at 10 year low ~US$38/tonne. Many miners are likely to go under – many don’t even break-even at this price, let alone make money. The next couple of years are not looking good for iron ore, and there is likely more pain to come. Most things you will read at present about iron ore, and the miners, will likely be negative. 

That said, Iron ore, the main raw material in steel manufacturing, is not going out of fashion. NMDC, with its strong balance sheet, and superior cost advantage, should be well placed to ride the low, and tap into the recovery when it comes. The commodity “super cycle” may be a thing of the past - iron ore prices are unlikely to touch the heights of 2010/11 - but the odds of them recovering to a more meaningful ~US$50-US$70/tonne in a few years are not bad. And when that happens, NMDC should gain handsomely. The key is - a long-term orientation & a contrarian mindset. 

Enterprise Inns plc - reset; what next for the stock?

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’:

• 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%. 

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. 

Management’s new strategy
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.

The below graph shows the portfolio as it stands currently

Source: Enterprise Inns preliminary presentation September 2015

The below graph shows the portfolio as predicted at September 2020, once the new strategy has been implemented

Having run the numbers, I do believe that the proposed strategy is the best option in front of the company. However, it comes with significant execution risks. In particular, the following challenges exist:

-        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.

I have used management’s predicted portfolio mix at the end of September 2020 as the starting point –management predict a portfolio consisting of 57% tied pubs, 24% free-of-tie pubs, and 19% managed pubs, in a total portfolio of 4200 pubs. This to me is the best case scenario. Using this as a base, I have added on a number of different scenario for the portfolio mix as at September 2020 and calculated the value of the stock for each scenario. My overall estimate is an average of the stock price for all the scenarios. Considering where we are today, I believe that these scenarios capture the range of possible outcomes appropriately. Obviously, as things evolve with the portfolio, I will be better able to adjust my range of possible outcomes. The below table summarizes the outcome:

You are welcome to review and play around with the detailed spreadsheet by downloading it here - https://drive.google.com/file/d/0B19r4lez4O3tMUVZY3BqMmhIWjQ/view?usp=sharing

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.