Resilient Pubs May Appeal to Investors More Optimistic on U.K.

Resilient U.K. Pubs May Appeal to Investors More Optimistic
Customers stand at the bar of the Lord Moon of the Mall pub, operated by JD Wetherspoon Plc, in London. Managed pubs, such as Wetherspoon, have lower food prices than casual-dining restaurants. Photographer Rupert Hartley/Bloomberg

Shares of pubs may attract investors who predict the U.K. economy will grow more than forecast, as consumers keep hoisting pints.

Sales rose 2.1 percent in November at managed pubs and restaurants open at least 12 months, according to the Coffer Peach Business Tracker. This marks six consecutive months of so-called like-for-like increases at 24 major chains amid renewed concerns about a U.K. recession, said Peter Martin, chief executive officer at Peach Factory, which tracks the data with KPMG LLP, UBS AG and the London-based Coffer Group.

“The frequency of eating out has remained quite solid,” said Martin, in Southport, England. “The pub industry has outperformed casual dining” as an “affordable treat.”

The data -- a proxy for the industry -- cover pubs that are managed by operators such as Mitchells & Butlers Plc and Spirit Pub Co., Martin said. December figures, due later this month, probably will reflect continued increases, as value-minded consumers choose pub fare in lieu of more expensive meals, he predicted, adding that bad weather in December 2010 also may help the comparison.

Even as sales remain positive, the newly-created Bloomberg U.K. Pub Index -- which includes Greene King Plc and Mitchells & Butlers -- has fallen 25 percent since Dec. 31, 2010, while the FTSE 350 Index is down 6 percent. That’s because investors have focused on “capital preservation,” shunning companies -- including pubs -- that are highly leveraged, said Robert Griffiths, a London-based pan-European equity strategist at Royal Bank of Scotland Group Plc.

Removing Debt

The pub industry’s average net debt, including operating leases, was 4.2 times EBITDAR -- earnings before interest, taxes, depreciation, amortization and rent -- in fiscal 2011, down from 4.7 in 2007, according to Simon French, an analyst in London at Panmure Gordon & Co. He estimates it will fall again to 4 times this year as companies continue to remove debt from their balance sheets. That’s still above the FTSE 350’s 2011 average of about 1.5 times, data compiled by Bloomberg show.

Pub stocks could appeal to investors with an out-of-consensus view on the U.K. economy because leverage is a “double-edged sword,” causing earnings to fall much faster during economic contractions and rebound more in an improving economy, Griffiths said.

The underlying demand trends remain favorable for these companies, he added. The Peach report indicates pub sales are faring better than retail sales, which increased 0.5 percent in November, excluding automotive fuel, from a year earlier, based on data from the Office for National Statistics.

‘Overweight’ Recommendation

Investors became more optimistic about the industry during the first half of 2011, until heightened concern about Europe’s sovereign debt surfaced, French said. Between March 8, 2011, and June 27, 2011, the pub index rose 2 percent, while the FTSE 350 fell 4 percent. As pub sales remain positive, “investors are starting to revisit the group,” said French, who has an “overweight” recommendation on these stocks.

The shares also are “relatively inexpensive,” French said. The group’s adjusted enterprise value -- the sum of equity and net debt including operating leases -- traded at a multiple of 8.3 times EBITDAR in 2011, which may drop to about 8 this year; that compares with 9.4 in 2007, he said.

Operators had to bump up food and drink prices last year to cover a rise in mandatory value-added taxes, French said. With no change in VAT this year, higher menu prices may support these companies’ bottom lines, he added, noting that increases have averaged about 2 percent to 3 percent a year.

Lower Food Prices

Managed pubs, such as JD Wetherspoon Plc, have lower food prices than casual-dining restaurants, said Peter Backman, managing director of London-based food-service consulting company Horizons FS Ltd. That means customers have more money to spend on drinks, which have a higher profit margin, he said.

Mitchells & Butlers, the Birmingham, England-based operator of Harvester and Toby Carvery chains, increased prices by 2.1 percent on food and 4 percent on drinks in the fiscal year ended Sept. 24, 2011, it said Nov. 22. Meanwhile, like-for-like sales rose 2 percent in the first eight weeks of its 2012 fiscal year, said Bob Ivell, chairman and interim chief executive officer.

“What we’re finding across most of our brands is that it’s pretty resilient out there,” Ivell said during the Nov. 22 earnings call. “We still think the consumers are going to treat themselves.”

Near-Term Risk

One near-term risk to his optimism is the U.K.’s exposure to the European economy and its sovereign-debt crisis, said George Buckley, an economist in London at Deutsche Bank AG. He forecasts the region will enter another recession this year, fewer than three years after recovering from its worst slump since World War II in the third quarter of 2009.

Another impediment may be high commodity-cost inflation, which continues to be the biggest drag on consumers’ discretionary spending, Buckley said. Housing costs -- which include electricity and gas -- were up 9.2 percent in November from a year ago, the biggest increase since February 2009, based on data from the statistics office.

“It’s going to take a long time for inflation to actually come down,” Buckley said. “Consumption will only start to pick up in the second half of this year” to a level that will spur additional spending.

Consumption adjusted for inflation -- a proxy for discretionary spending -- still lags behind prerecession levels, down about 5.5 percent from its peak in the fourth quarter of 2007, Buckley said. Meanwhile, U.K. unemployment held at 8.3 percent in October, the same as the prior month and the highest since 1996.

Growth Forecast

While gross domestic product accelerated more than previously estimated in the third quarter -- up 0.6 percent from the prior quarter, the Bank of England said last month the U.K. may fail to grow in the first part of this year. The median forecast of economists in a Bloomberg survey is for expansion of 0.6 percent in 2012.

Still, there are signs of life. Household income adjusted for inflation fell 1.5 percent in the quarter ending Sept. 30 from a year earlier, up from a 21-year low of minus 4.1 percent, data from the statistics office show. The Bank of England continues to forecast that real income will “return to growth in 2012, which would provide some support to consumption spending,” policy makers said last month.

In the meantime, pub companies aren’t “complaining about a slowdown in demand” and are working to manage costs, making their stocks more attractive to investors, French said.

“The trend of people eating out more often at the major U.K. pubs remains on-track,” he said.

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