The Leased Pub Sector: What does the future hold?

Whilst we can see the possibility of a good outcome for the managed pub industry, the outcomes for leased pubs seems far less certain. At the moment, I don’t see much opportunity in the equity of these companies (although given the complexity, I would imagine there is some value in a capital structure arb). Despite this there is definitely some value in understanding these companies as they constitute an important part of the overall pub industry and will influence the outcome for managed pubs. I will briefly summarize some of the main issues discussed in the last post (on managed pubs) and link them to the leased pub business model.

The main question facing the industry is: Does the tied business model work? It’s a difficult question but, probably not. The key to answering this question is working out what these companies do and how they fit into the industry. If you think the leased model serves a useful purpose then these companies will make a comeback after shedding overcapacity. However, it is somewhat difficult to see what purpose they really serve outside of financial engineering. Indeed, all these companies appear to do (in terms of their actual operations), especially in the case of Punch and Enterprise, is speculate on the value of property/pubs. They take capital from markets, buy pubs and lease them out. Indeed, in a time of rising property prices there is clearly no incentive to secure the viability of the underlying pub business as the company has the security of the property (which always gets more valuable, of course).

On the other hand, the only time this model fell apart is when the financing part of the business went wrong. The financial burden of the debt meant the company placed more pressure on its lessees resulting in complete operating failure. Despite this, some, or even most, of the underlying pubs probably are viable as underlying businesses (given lower fixed costs and freedom to price competitively). Therefore, value can be created by transferring these pubs back to freeholds. However, the debt still remains (a restructuring by the end of the year seems certain for Punch) and there won’t be a lot of good bids for these pubs. Either way, these asset sales are going to be important for the future of these leased pub business. So the question of whether these companies can survive as smaller business is probably up for debate. The reality of the next year or so is asset sales and if these don’t go well then it won’t matter if the leased model is or isn’t workable.

(I have used the same data source so the figures for market cap are off and the EV/EBIT is most likely off as well)

The two big groups here are Punch Taverns (LON:PUB) and Enterprise Inns (LON:ETI) with 80% of the total number of leased pubs and 81% of total sales of leased pubs. Again, with Greene King (LON:GNK) we have the average number of pubs through FY10 rather than the year end. At this stage, we should repeat the basic difference between leased and managed pubs. The leased pubs make money through the rent and drinks income (the contracts here are changing as this is something of a massive problem for lessees) made from their pubs. Another way of putting it is that the pubcos set a fixed cost for running the pubs it leases.

(These figures are for the pubcos sales/income not the operator/lessee)

Valuation/Competitive Trends – It is somewhat difficult to separate the issues of valuation from rather pressing competitive trends so I will have to mix these two points into one discussion for the purposes of this topic. I should also add from this point on I have had a tremendous amount of help in getting to grips with industry/numbers/themes from Phil/liquiddevil of Stockopedia.

The first thing to point out is how, on a per pub basis, less profitable the leased pubs business is than managing them. If we think about it, this makes sense as the leased pub model is a bit like a fixed income investment. The pubcos get all of the downside of the potential failure of the business (with the collateral of the property) but their upside is limited to the drinks/rent charges.

Unsurprisingly, the pubcos are slightly wary about publishing detailed figures of the costs of running their leased operations and it is also difficult to put a price on the value of the economies offered through the bulk buying of drinks. Taking ETI as an example though (they are a pure leased business so it is most transparent) they spent around £275m on drinks and sold these on for just over £500m leaving a profit of £225m, leaving a margin of around 80%. In addition, my source quotes a price of £115 for a keg of Fosters bought from a pubco against a free of tie price of £65, a 76% margin which he believes to be representative of conditions across the product portfolio. Now to achieve this huge margin all ETI did was act as a buyers co-operative/distributor. This seems like a pretty good deal considering that most co-operatives would probably have to give up some equity ownership to their members as well. However, this money clearly isn’t coming from nowhere as these margins are being achieved at the expense of the lessees. While it is certainly true that the leased pub business has a purpose in offering lessees the access to cheap capital through their securitizations, when the consumer environment turns down these kind of margins are just too much.

I don’t know what kind of margins normal distributors would be charging but, to be conservative, lets say its 10%. So for the same amount of drinks ETI lessees would have paid £303m, the difference here is around £195m. On a per pub basis this £195m (£195m/6820) is £28.6k per pub that appears to go to the pubcos instead of freeholders. Interestingly, my source (who operates tied and freeholds) finds a roughly similar number working up from an individual pub level and making an assumption of £5k in turnover per week. Within this we get the difference between buying and selling price. In free of ties this is around 68% whereas for Punch sites this is closer to 58% suggesting the tie is worth that 10% difference in profit. However, I should highlight that the selling price is often roughly the same, according to my source, so the money is being lost in margins/excessive fixed costs for the operator. There is some more maths that could be done here but the general picture is clear. £26k sure seems like a lot of money considering that the average managed pub, discussed in the previous post, make £14k in operating profit in the previous year. Therefore, although we only have access to averages and we don’t have a clear breakdown of ETI’s costs/sales we can see that the current ownership of pubs isn’t optimal.

Now this may be a slightly labored discussion but I realize that the issue surrounding pubco’s profit is a controversial and emotive issue for many people. My point though is that under the current system this doesn’t work and in the long run this won’t continue as people like money. The pubcos, of course, have realized this problem. My source notes the development of “free of tie” leases whereby drinks are sold at market prices but rents are higher than under the other agreements. I will look at the lease side later but my source contends that leases under the original agreements are close to market so these new agreements rely on charging above-market rates. The simple fact then is that the drinks side of the tied model is dead. Now, it isn’t a problem getting rid of ties when your cost structure is flexible but the pubcos are leveraged for these 80% margins. So there are two conclusions: first, in the future if the leased model is to survive then it will have to be on free of tie prices and second, there is value, for operator/owners in buying these leased pubs as they can operate with far less operating leverage.

One area that I didn’t consider but my source highlights is the income from food sales. Under the ties, it is all drinks except wine and spirits that are bought from the pubcos. I am not really too sure what this means but there is the potential here for operators to earn more margin. As the industry moves in this direction, this will surely become more important.

All this is well and good but this leaves out the other, more important side, of what pubcos do which is offer the link to cheap finance for its lessees, a fairly easy way into the business and a network of support services. The cheap finance bit seems slightly redundant considering the current financial position of these companies but there is potential here as the pubcos appear to be doing something useful. However, the incentives seem skewed. The pubcos wanted as many lessees as possible, the lessees wanted pubs but weren’t exposed to the same downside of owning the business if everything went wrong. In addition, it turned out that the pubcos were also exposing themselves to a big chunk of property price risk. However, this rent side of the business probably isn’t fundamentally broke in the same way as the drink business is. Indeed, the transaction between the pubco and lessee creates value if the cost of rent charged to the lessee is lower than the interest/principal charged to the freeholder who has taken out a mortgage or what the pubcos annual interest expense is (assuming they have better credit than the freeholder alone). Looking at ETI and PUB, this isn’t the case even if we assume that rental income is pure profit (the pubcos have to keep up maintainance and the like). For ETI, rental income is roughly equal to finance expenses and for PUB, finance expenses are 48% higher than rental income. On a per pub basis, ETI are charging around £31k per annum in rent whilst PUB are charging just under £30k (the difference seems to be PUB’s poor debt management). Either way, the picture we get is that business is just currently too leveraged for the margins in the future without the same level of drinks income.

Now its really tough to put this altogether into a valuation (I will do another post on Punch soon) and I would encourage interested readers to put this together themselves. The basic fact though is that far less money will be made from the tied drinks deals and both of the big pubcos will need to go through serious debt restructurings to preserve the rent income side. I would add that it is possibility that the equity will be worth nothing after these restructurings. Another important factor are the asset sales. From the valuation figures my source has quoted, the book value of these properties is way off. My source also highlighted a more interesting point though, noting that currently, these sites are worth far more to Punch than a freeholder because of the drinks income.  This is important as it suggests we aren’t at the fire sale/liquidation stage which is obviously quite worrying for shareholders who are hoping for some residual after the restructurings. So the next post will go straight in and build out some of these numbers for Punch but the above will guide my thinking about the future of the industry.

Disclosure: Long Punch Taverns (LON:PUB)

Again I would like to highlight that a lot of the information in this post was provided by liquiddevil who has been extremely generous with his time and knowledge about the industry.