Fuller's, Marston's and M&B: asset plays or value traps?

It has been a strong couple of days on the stock market. In fact, Tuesday was the second best day ever in the c25 years that the FTSE has maintained its all-world index. It is worth remembering, though, that the biggest ever one day gain back in 2008 was more a result of the preceding days having been so relentlessly negative, rather than any fundamental improvement in the economy. From that point, markets still had a long way to fall.

Whatever this current bounce means for us in the short term, I remain optimistic long term and I feel that there must be some excellent investment opportunities knocking around right now. My working assumption is that the COVID growth curve will be flattened and eventually bent downward in three to six months, depending on:

• How well people self isolate,
• How well we can test, identify, and separate those with the disease,
• The degree to which warmer seasonal weather might dampen the spread, and
• The development of an effective vaccine

I think we are also set for a steady stream of negative news flow, including:

• Business closures,
• Job losses,
• Supply chain disruption,
• Share placings and equity dilution as companies increase cash cushions,
• Strained health services.

The spread of COVID and society’s reaction to it is doing funny things to the economy. For health and safety reasons, we are essentially imposing a recession upon ourselves.

The UK flash PMI readings for March showed the biggest hit to output since their launch more than two decades ago. The composite PMI fell to 37.1 (from 53.0 in February) and is consistent with GDP contracting by between -1.5% and -2% quarter-on-quarter. New orders fell at the fastest pace since 2008 and business expectations were at the lowest ever.

The manufacturing PMI fell from 51.7 to 48.0 and the Services PMI collapsed from 53.2 to 35.7, with the greatest weakness in hotels & restaurants, sports centres, and transport and travel.

Many hospitality businesses are suffering and a lot might not survive these conditions. That said, pub companies such as Fuller Smith & Turner (LON:FSTA), Mitchells & Butlers (LON:MAB) and Marston's (LON:MARS) have been around for more than a hundred years each (closer to two hundred, in Fuller’s case). I think they will continue to operate for a long time yet, although there is no doubting the seriousness of their current plight.

Placings, equity dilution and liquidity cushions

We have seen a wave of dividend suspensions. Given the exceptional circumstances, might we be about to see a wave of equity placings, too? This is an example of the heightened risk to shareholders around at the minute. While stock prices may have fallen due to a temporary shift into less risky assets, things like equity placings at lower share prices can permanently dilute your holding in a company.

But share placings at reduced prices will be exactly what some companies are considering, and with good reason. For many now, it is a question of survival and having a large enough liquidity cushion to survive months of shut down assets, minimal cash flow, and government aid (the mechanics of which, after all the bombastic, market moving announcements, remain to be thrashed out).

Off the top of my head, recent placings include:

• Ssp (LON:SSPG) - raising £216m at 250p per share
• Ten Entertainment (LON:TEG) - raising £5m at 155p per share
• Arena Events (LON:ARE) - raising £9.5m at 10p per share

Are there more to come?

Affected companies will want to have at least six months’ worth of cash. Many operators will not have that cushion right now, meaning those that have access to public markets may be tempted to take advantage. Pub companies with lots of freehold assets might be more tempted to take on more debt, rather than raising equity. A large freehold estate gives you more financing options - for example, you can sell and leaseback properties.

A helping hand in trying times

The operators that make it through will have more debt, but there will also likely be substantial equity upside and a less crowded market. As for costs - in these exceptional times we are seeing fixed costs such as rent and wages become variable, and some of those variable costs are now being temporarily funded by the government. For the sectors that have been worst affected, tax, staff and rent are the three big expenses (excluding cost of sales)

• Tax - business rates holiday in ten instalments
• Staff - coronavirus job retention scheme
• Rent moratorium

Intu Properties (LON:INTU) ‘s statement today makes for some interesting reading. The struggling landlord says:

Rent for the second quarter of the year in the UK was due on 25 March (the quarter day) and we have received 29 per cent of this. We are in discussions with our customers on the outstanding rents. For the same period last year, we had received 77 per cent on the quarter day.

The government is bailing everyone else out. Is it only a matter of time before landlords get bailed out as well?

Yesterday saw Marston's (LON:MARS) bounce by more than 40%. In these uncertain markets, there are undoubtedly some big (but risky) opportunities and it pays to have a view, one way or the other.

My view is that, as such large employers, the government will support pub companies through this lockdown. Debt will increase, but on balance I feel like the possibility of equity getting diluted or wiped out is less likely for some of these operators given their freehold estates, profitable operating track records, and established banking relationships.

I’m going to stick my neck out and say that listed pub companies represent an intriguing contrarian investment opportunity - although this is a risky call to make and we can no longer rely on pre-COVID 19 broker forecasts.

Make no mistake - this part of the stock market should be accompanied with a large “Investor Beware” caveat for as long as this lockdown is in place. Even after it gets lifted, there is no guarantee that business will revert to previous levels. The question is what is now priced in for these companies?

Marstons (LON:MARS)

• Year-to-date share price performance: -67%
• Price to tangible book value: 0.56
• Cash: £38m
• Debt: £1,438m
• Net plant, property and equipment: £2,350m
• Market cap: £277m
• Enterprise value: £1,675m

Even though it is backed up by a large freehold estate, some think MARS has too much debt. This prompted Marston's (LON:MARS) to last year launch a debt reduction programme, with a target to reduce debt by £200m by 2023.

The group has ceased its new-build programme, reducing capital expenditure by approximately £80m per year and increased the disposals target for this financial year from £45m to £85-90m. I would expect asset values are down in this market, though. It can also suspend its interim dividend, which would retain c£20m in the business.

So far, the group has:

• Significantly reduced capital expenditure,
• Reduced overhead and other variable costs,
• Is tightly managing working capital levels,
• Is working to suspend tenant and lessee rent on a case by case basis,

In terms of liquidity, management says:

We have appropriate headroom on both our bank and securitised facilities, supported by a 93% freehold estate. As a consequence of this, and the actions we have taken to date, we believe that we have sufficient liquidity to maintain operations at a materially reduced level of business...

In addition, we are having discussions with our banking group about the provision of covenant waivers for the second half-year, in the event these should be required. Whilst at an early stage, those discussions have been constructive.

It is worth mentioning that Marston’s still has a large brewing operation, which should bring in some revenue during the lockdown.

Mitchells & Butler (LON:MAB)

• Year-to-date share price performance: -61%
• Price to tangible book value: 0.37
• Cash: £133m
• Debt: £1,752m
• Plant, property and equipment: £4,528m
• Market cap: £715m
• Enterprise value: £2,332m

M&B is cutting costs, has a strong balance sheet and says it has headroom, under most circumstances, to meet its covenants. As with Marstons, a large chunk of government initiatives will apply to this company. The group has suspended its capital programme and is reducing costs across the business.

According to management:

The group currently has a strong balance sheet with material cash resources which should be sufficient to fund obligations through the half year on 11 April 2020, and well into the second half. The next securitisation restricted payment and covenant test is at the half year. Sufficient headroom has been established such that we believe the group could suffer a significant loss in the remaining four weeks to the test date and still clear covenant levels.

Fuller’s (LON:FSTA)

• Year-to-date share price performance: -34%
• Price to tangible book value: 0.45
• Cash: £44m
• Debt: £163m
• Plant, property and equipment: £656m
• Market cap: £277m
• Enterprise value: £331m

Fuller’s is in a strong financial position. It has a good relationship with its lending banks, and the company is well financed with a healthy balance sheet and significant liquidity headroom. It has less debt and better liquidity ratios than either of its peers. Furthermore, the group has a high quality asset base of premium pubs and hotels, which is 89% freehold by book value.

The Group is preserving cash and reducing overhead costs through a range of measures including delaying the start of larger capital expenditure projects. It can also cut its dividend.

Chief Executive, Simon Emeny, recently said:

Fuller's is a long-term business, established on extremely sound foundations, which equips it well to navigate testing times such as these. This will end and, when it does, we will be ready to welcome our customers into our wonderful pubs and hotels and provide the fantastic food, drink and exceptional service that we have been delivering for nearly two centuries.

Conclusion

These companies have been around for centuries and, on balance, I feel it is likely that they will continue to exist for a long time.

The near term future is uncertain, and I must stress that earnings forecasts are currently meaningless. In the longer term, if trade can recover, then asset values might provide some share price protection. Right now these companies trade at pretty steep discounts to tangible book value. As the lockdown continues, this discount will narrow as liabilities increase and asset values will likely soften.

That said, current valuations may offer some margin of safety. Big, publicly-listed companies with better access to funding, track records of profitable growth, and more established relationships with banks are far more likely to survive than smaller, newer operators. No doubt, pub companies are capital intensive businesses but they are an important part of our culture and are backed by largely freehold estates. As such, my view is that there could be contrarian value here although the risks remain considerable. Views welcome and, as always, DYOR.