Greene King - the brewer CAMRA loves to hate

Greene King is the brewer CAMRA loves to hate. It's been an acquisitive company, buying Ridley's, Hardy's and Hansons, and Morlands, as well as Belhaven Brewery, and closing down many of the breweries to concentrate brewing at its Bury St Edmunds site. It's not by any means the only brewer to play this game - but it's the largest.

It has also acquired hotel and restaurant businesses, including Old English Inns - which is where my involvement with Greene King began, since I was an OEI shareholder at the time.

Greene King now has four separate businesses. First, there's the retail division, including managed pubs, restuarants, and hotels. Then there's Pub Partners which runs the tenanted pubs. There's the brewing company, which does what it says on the tin (sorry, cask). And then there's Belhaven, the Scottish brewing and pub company, which is managed as a separate entity. GNK is a reasonable sized business, with 2,500 pubs in the UK - Enterprise and Punch each have about 7,000, Marstons about 2,000 - and two breweries (Bury St Edmunds and Dunbar). Though that brief description doesn't show you just how dominant GNK is becoming in the cask ale business in the UK - more about that later.

Full year results to May 2009 were reasonably robust, in a tough economic environment. Revenues rose 1.3% to £955m, and operating profit fell 6.7%, with the operating margin falling from 24.6% to  22.6% - still above the competition; Marston's Plc and Mitchells & Butlers came in around 15%, and managed pubs operation Wetherspoon(j.d.) around 10% [ref] Results presentation to analysts, http://ww7.investorrelations.co.uk/greeneking/reports/index.jsp?cat=3/ [/ref] . (It's worth noting that Marston's Plc saw a worse decline in business at its interims, with a 9% fall in operating profit, though the two sets of results are not strictly comparable.)

Perhaps more to the point in an environment dominated by the rescue of heavily indebted Punch and Enterprise Inns, GNK was the only major player in the sector to pay down debt in the period. That didn't stop it holding a rights issue - but with the focus on getting a war chest together for opportunistic purchases, rather than being driven by refinancing needs.

And in a most unusual move for the sector, indeed for the market as a whole, GNK increased its dividend - albeit by the puny amount of a tenth of a penny, from 20.9p to 21p.

The chief problem last year wasn't a dip in sales - it was climbing costs, which affected all divisions of the group. In particular, food price inflation was high, energy costs also rose, and anyone who brews will tell you that prices of hops went through the roof, some more than tripling. (Mind you, if you get very technical, that probably hurt brewers who use American and European hops like Cascade, Saaz and Tettnang,  more than GNK, which uses mainly English varieties such as Goldings and the charmingly-named Fuggles.) The good news is that cost pressure is expected to moderate this year; so there's room for GNK to push operating margins back up a little, perhaps.

GNK is certainly looking for growth - not just trying to stay stable. For instance in the Hungry Horse business, it actually managed to get like-for-like sales increased in 2009, though that does compare to a very poor 2008 financial year, and it's looking for a 10% increase, or better, next year [ref] Site visit presentation, p18: http://ww7.investorrelations.co.uk/greeneking/reports/index.jsp?cat=3/ [/ref] . Stressing value for money has obviously been a profitable marketing ploy.

Loch Fyne, the upmarket seafood restaurant chain, hasn't done so well; expansion is now on hold, which seems a sensible decision given the state of the economy.

In pubs, GNK has been making a number of changes recently. First of all, it split the 'destination pubs' from 'locals', achieving a clearer focus in each area. Then in its tenanted business, 'Pub Partners', it split out 400 properties for the more entrepreneurial and wet-led Independence Pub Company, leaving the remaining 1060 in Pub Partners. This segmentation of the portfolio should help focus management attention on the right areas in each of the sub-strands - though it's a bit early to tell if it's working. Not all Greene King tenants are happy with the moves, but they don't seem to be nearly as vocal as cheesed-off Enterprise or Punch tenants. It's a nicely diversified portfolio - not all one type of pub, so hopefully shouldn't suffer from the kinds of problems that have beset niche operators such as Pubs'n'Bars or Regent Inns.

The brewing business is probably the strongest in the UK that isn't controlled by a multinational. It has four core brands - Old Speckled Hen, IPA and Abbot, and Belhaven (north of the border only) - which all saw gains in market share and volume in the second half of last financial year. Greene King IPA, the lead brand, has a 20.5% share of the standard cask market - helped, obviously, by its status as one of the regulars not only in the Greene King tied estate but also at Wetherspoons. Old Speckled Hen has a13.3% share of premium off-trade, and Belhaven Best has a 20% share of Scottish ale market  and is the leading ale (a real poke in the eye for Caledonian, whose Deuchars IPA is a much superior ale in my view but has only 3% of the market).

Revenues for brewing last year were up 8.2%, with volume sales up 1.8% despite a 5.6% dip in the UK ale market as a whole [ref] Annual Report, p 14: http://ww7.investorrelations.co.uk/greeneking/reports/index.jsp?cat=3 [/ref] . Despite cost pressures, operating profits were maintained.

Meanwhile 2008-9 was a vintage year for Belhaven. This separate business is slightly more than a third in tenanted pubs, and slightly less than a third each in brewing and managed pubs; it saw sales up 10%, and profit up 12%.

This all looks slightly boring till you consider the economic environment, and the fact that Greene King was not only cash generative last year, but managed to pay back £46m of debt. The group still has borrowings, but its bank facility is committed till 2012, so it has no immediate financial constraints.

What I really love about this stock right now is the valuation. It's trading on 6x historic earnings, and even if you factor in a 20% to 25% cut in profits, that's still only 8-9 x prospective earnings. It's the only major player to have maintained its dividend - Marston's Plc cut its divi, while Wetherspoon(j.d.), Punch and Enterprise Inns have given up paying them altogether. Meanwhile, GNK is targeting 2x dividend cover, which is a sensible and sustainable level [ref] Results presentation, p 13 [/ref] . This gives the stock a yield of 5.5% yield - impressive, in fact above several of the supposedly high-yielding utilities stocks.

Yet GNK has underperformed the nearly-bust Enterprise Inns and £PUB. It has risen from about 300p to just above 400p, true - but the other stocks have more than doubled.

I suspect that underperformance is coming to an end. For a start, GNK has some key assets that the pubs don't - its beer brands. Its management believes the sector is polarising [ref] Results presentation, p16 [/ref] , and I think they're quite possibly right. There's room for managed chains like Wetherspoon(j.d.), and there's room for brewery ties - whether the other pubcos can compete in the long term is doubtful, particularly given their huge debts, which mean they won't be able to invest in their pub assets. (And a down-at-heel pub is a horrible thing.)

GNK seems to be a bit  'under the radar' at the moment, though the well rated Investec Smaller Companies fund has made it, together with Marston's Plc, one of its favourites [ref] Citywire:The best small-cap income opportunities: http://www.citywire.co.uk/professional/-/news/income/content.aspx?ID=368828&Page=1 [/ref] . In almost all the many articles about building an income portfolio, Greene King's name is missing - perhaps journalists think its £869m market capitalisation isn't enough to recommend it to retail investors? Instead I see names like Centrica (pays less than GNK), “Royal Dutch Shell B (pays less than GNK), and even Tesco (pays less than half what GNK does).

Okay, yield isn't everything. But this looks to me like a strong and modestly valued business with great cash flow. And my experience of brewing in recessions has been that while people put off the big ticket purchases, and trade down from Waitrose to LIDL, if they go to the pub on Thursday night for a couple of pints, that's one of the last things to get cut. (One of my friends runs a micro-brewery and tells me he has never been so busy. But then, he does brew rather good beer.)

My view on the great CAMRA debate? I have had a couple of truly great pints of Greene King IPA in my life - and many more rubbish ones. But at least, unlike Bass and Whitbread in their dying days, Greene King under CEO Rooney Anand does have a commitment to brewing cask ale. And a commitment to paying dividends, too!